Atkinson, Solution Manual t/a Management Accounting, 6E
Chapter 6
Measuring and
Managing Customer
Relationships
QUESTIONS
6-1
Nonfinancial measures such as customer satisfaction and customer loyalty are
important in managing relationships with customers, but an excessive focus
on improving customer performance with only these metrics can lead to
deteriorating financial performance. To balance the pressure to meet and
exceed customer expectations, companies should also be measuring the cost
to serve each customer and the profits earned, customer by customer.
6-2
Examples of differences between customers who have high and low costs-toserve may be drawn from the chapter’s Exhibit 6-1, part of which appears
below.
High Cost-to-Serve Customers
• Order custom products
• Small order quantities
• Customized delivery
• Manual processing; high order
error rates
• Large amounts of pre-sales
support (marketing, technical,
and sales resources)
• Large amounts of post-sales
support (installation, training,
warranty, field service)
• Pay slowly (have high accounts
receivable from customer)
– 196 –
Low Cost-to-Serve Customers
• Order standard products
• Large order quantities
• Standard delivery
• Electronic processing (EDI)
with zero defects
• Little to no pre-sales
support (standard pricing
and ordering)
• No post-sales support
• Pay on time (low accounts
receivable)
Chapter 6: Measuring and Managing Customer Relationships
6-3
Companies should not necessarily avoid high cost-to-serve customers. The
high cost of serving such customers can be caused by their unpredictable
order patterns, small order quantities for customized products, nonstandard
logistics and delivery requirements, and large demands on technical and sales
personnel. Activity-based pricing may be used to ensure that companies
charge prices that are high enough to cover the high costs of serving such
customers. Customers may, in response, change their behavior to become
lower cost-to-serve customers. Companies may also improve the process used
to produce, sell, deliver, and service customers in order to improve customer
profitability.
6-4 The 80-20 rule as applied to sales revenues refers to the common finding that
when companies rank products and customers from the highest sales volume to
the lowest, they generally find that their top-selling 20% of products or
customers generate about 80% of total sales.
6-5 The typical shape of a graph of cumulative profits versus percentage of
customers ranked from most profitable to least profitable is a “whale curve,” in
which the most profitable 20% of customers generate about 180% of total
profits; this is the peak, or hump of the whale above sea level. The middle 60%
of customers approximately break even, and the least profitable 20% of
customers lose about 80% of total profits, leaving the company with its 100%
of total profits (“sea level” in the whale curve represents the company’s actual
reported profits). The hump (or maximum height) of a cumulative profitability
curve generally hits 150% to 250% of total profits, and this height is usually
achieved by the most profitable 20% to 40% of customers.
6-6 Service companies, even more so than manufacturing companies, must focus
on customer costs and profitability sales because the variation in demand for
organizational resources is much more customer driven than in manufacturing
organizations. A manufacturing company producing standard products can
calculate the cost of producing the products without regard to how their
customers use them. In this sense, the manufacturing costs are customer
independent. Of course, the costs of marketing, selling, order handling,
delivery, and service of the products might be customer specific. For service
companies, in contrast, customer behavior determines the quantity of demands
for organizational resources that produce and deliver the service to customers.
6-7 Consider customers who maintain checking accounts at a bank. One customer
may maintain a high cash balance in his checking account; make very few
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Atkinson, Solution Manual t/a Management Accounting, 6E
deposits, withdrawals, balance inquiries, or service requests; and use only
electronic channels (i.e., automatic teller machines and the Internet). Another
customer may manage her checking account balance very closely, keeping only
the minimum amount on hand, and use her account heavily by making many
small withdrawals and deposits via manual transactions with bank tellers. The
consequence of the customers’ very different use of the bank’s resources is that
the second customer is much more costly to serve than the first customer.
6-8 The four broad groups of actions that managers might use to transform
unprofitable customers into profitable ones are:
 Improve the processes used to produce, sell, deliver, and service the
customer.
 Deploy menu-based pricing to allow the customer to select the features
and services it wishes to receive and pay for.
 Enhance the customer relationship to improve margins and lower the cost
to serve that customer.
 Use more discipline in granting discounts and allowances.
6-9 A pricing waterfall chart depicts the multiple revenue leaks from list price
caused by special allowances and discounts granted to obtain the order and
build customer loyalty.
6-10 Salespersons’ incentives or compensation plans that set minimum quotas and
commissions based on sales revenue, and tie bonuses and rewards to achieving
sales revenues above a stretch target contribute to unprofitable customer
relationships. Such arrangements encourage salespeople to close deals and
generate revenues without regard to the cost of fulfilling the special
arrangements negotiated in the deal and the impact of discounts and
allowances granted to close the deals.
6-11 Life-cycle profitability analysis weighs the expected value of the stream of a
customer’s net margins against the cost of acquiring the customer. Companies
must understand variation of customer demands across multiple products and
services and the expected length of each customer’s relationship with the
company (given potentially costly retention efforts), in order to calculate each
customer’s total life-cycle profitability. The analysis involves identifying
characteristics of profitable customers. Companies can then direct their
marketing efforts accordingly to specific segments that are most likely to yield
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Chapter 6: Measuring and Managing Customer Relationships
and retain profitable customers. Acquiring the information necessary for lifecycle profitability analysis and using this information to calculate life-cycle
profitability thus provides insights about which customer groups are likely to
be profitable over the expected life of a customer’s relationship with the
company.
6-12 No. Experts now agree that it is a mistake for a company to use the
satisfaction score as its only customer metric. A customer’s satisfaction is an
attitude or belief stemming from a feeling that the product or service has
generally delivered on the customer’s expectation of performance. But having
attitudes and beliefs are not actions; a customer’s attitude toward a product or
a company does not readily translate into the desired behavior of repeated and
increased purchases of the product or service, or customer loyalty.
6-13 Loyal customers are valuable for several reasons. Three reasons are required
in this question; the chapter lists the following five reasons:
1. Loyal customers have a greater likelihood to repurchase, and the costs to
retain them are generally much lower than the cost to acquire an entirely
new customer.
2. Loyal customers can persuade others, through word of mouth, to become
new customers; they can become references for potential future customers.
3. Loyal customers are less likely to defect when a competitor offers a similar
product at the same or slightly lower price.
4. Loyal customers are often willing to pay a price premium to retain a
known and trusted relationship with a key supplier.
5. Loyal customers are willing to collaborate with the supplier to improve
performance and develop new products.
6-14 Customer retention rate, though a traditional customer loyalty metric, is a poor
indicator of a customer’s loyalty. This is because customers often remain with
their current supplier because of inertia, high switching costs, or the current
lack of an alternative supplier.
6-15 The five stages of a hierarchy for categorizing customer satisfaction and
loyalty are:
1. Satisfied customers, as measured by how well a customer’s expectations
have been met or exceeded in an individual transaction or long-term
relationship.
2. Loyal customers, as measured the customer devoting an increasing “share
of wallet” for repeat purchases from the same supplier.
3. Committed customers, those who not only purchase frequently from the
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Atkinson, Solution Manual t/a Management Accounting, 6E
supplier but also tell others about the supplier’s great products and service.
4. Apostle customers, committed customers who have credibility and
authority when they recommend the supplier to friends, neighbors, and
colleagues.
5. Customer “owners,” who take responsibility for the continuing success of
the supplier’s product or service.
A company should strive to have more of its customers in categories 3, 4, and
5 above, since their willingness to recommend the company to others and to
collaborate with it to continually improve product features and service makes
them far more valuable, with a much higher customer lifetime value, than
customers who are merely satisfied with the most recent transaction.
Companies that offer personalized services to customers, such as by a
Nordstrom salesperson, or that offer rewards to loyal customers can generate
high customer loyalty. These loyal customers then recommend the companies
to others. Online companies such as amazon.com generate customer loyalty
because provide a good selection of desired products, competitive prices, easy
ordering, quick delivery, and reviewers’ comments on products. Loyal
customers, in turn, provide comments on products; helpful reviews in
conjunction with the other positive attributes of the company contribute to
continuing and growing customer loyalty.
6-16 The net promoter score is computed based on responses to the question, “How
likely is it that you would recommend [Company X] to a friend or colleague?”
Customers respond on a scale from 1 (extremely unlikely) to 10 (extremely
likely), with 5 representing a neutral point. The net promoter score is the
percentage of customers who are “promoters” (score of 9 or 10) less the
percentage who are “detractors” (scores of 1 through 6). The net promoter
score is recommended based on research that finds that a customer’s
willingness to recommend a company is strongly correlated with future
growth and profits. In contrast, a customer retention rate, a traditional
customer loyalty metric, can be a poor indicator of a customer’s loyalty. This
is because customers may remain with a supplier because there no alternatives
or simply because of inertia. Research suggests that “promoters” are the only
truly loyal customers and “detractors” may harm the company’s reputation
and brand value.
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Chapter 6: Measuring and Managing Customer Relationships
EXERCISES
6-17
(a)
(b)
(c)
6-18 (a)
Sales
Cost of goods sold
Gross margin
Marketing, selling, distribution, and
administrative expenses: 33% × sales
Operating profit
Operating profit/Sales
Sales
Cost of goods sold
Gross margin
Marketing, selling, distribution, and
administrative expenses
Sales representative travel
Service customers
Handle customer orders
Ship to customers
Total activity expenses
Operating profit
Operating profit/Sales
Ashton
$430,000
$220,000
$210,000
Brown
$350,000
$155,000
$195,000
$141,900
$68,100
15.84%
$115,500
$79,500
22.71%
$430,000
$220,000
$210,000
$350,000
$155,000
$195,000
$9,000
15,000
1,000
24,000
$49,000
$161,000
37.44%
$42,000
110,000
12,000
72,000
$236,000
–$41,000
–11.71%
The activity-based costing method provides more accurate assignments
of marketing, selling, distribution, and administrative expenses by
identifying activities consumed by each customer and assigning costs
to customers based on their activity usage. In this example, Brown
places smaller orders, orders more frequently, and requires more aftersales support (travel and service support) than Ashton does.
$873,600/20 operators = $43,680 per operator
$43,680/1,560 productive hours/operator = $28.00 per hour
(b)
(i)
0.1 + (10 × 0.02) = 0.3 hours
0.3 hours × $28/hour = $8.40
(ii)
0.06 hours × $28/hour = $1.68
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Atkinson, Solution Manual t/a Management Accounting, 6E
6-19 (a)
Students can refer to the In Practice box on textbook page 224. The
following table shows the customer profits sorted from largest to
smallest, the cumulative profit after adding each customer, and the
cumulative profit percentages that were used to plot the whale curve
shown below. In addition, the first row (rank 0) was included below so
that the graph begins at 0.
Customer
Sorted
Cumulative Cumulative
Number
Profit
Profit
Profit %
0
$
0 $
0
0%
13
264,000
264,000
31%
9
259,000
523,000
61%
12
233,000
756,000
88%
1
221,000
977,000
114%
4
217,000
1,194,000
139%
11
208,000
1,402,000
163%
7
101,000
1,503,000
175%
10
96,000
1,599,000
186%
22
87,000
1,686,000
197%
14
83,000
1,769,000
206%
25
75,000
1,844,000
215%
17
50,000
1,894,000
221%
20
30,000
1,924,000
224%
5
22,000
1,946,000
227%
16
14,000
1,960,000
228%
6
9,000
1,969,000
229%
21
- 10,000
1,959,000
228%
2
- 40,000
1,919,000
224%
19
- 90,000
1,829,000
213%
24
-100,000
1,729,000
202%
3
-143,000
1,586,000
185%
23
-158,000
1,428,000
166%
15
-179,000
1,249,000
146%
18
-191,000
1,058,000
123%
8
-200,000
858,000
100%
– 202 –
Cumulative
Percent of
Customers
0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%
44%
48%
52%
56%
60%
64%
68%
72%
76%
80%
84%
88%
92%
96%
100%
Profit
Rank
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
Chapter 6: Measuring and Managing Customer Relationships
Cumulative Customer Profitability
Cumulative Profit Percent
250%
200%
150%
100%
Actual net profit
Actual net profit
50%
0%
0
20%
40%
60%
80%
100%
Cumulative percentage of customers, ranked from most-to-least profitable
(b)
The most profitable 20% of the customers (i.e., the most profitable 5
out of 25 customers) generated 139% of the profit, as shown in the
table in part (a).
(c)
The least profitable 20% of the customers (i.e., the least profitable 5
customers) lost (202% – 100%) = 102% of the profit.
6-20 (a)
A company might transform its breakeven or loss customers into
profitable ones through process improvements that lower the costs of
serving customers. For example, if most customers are migrating to
smaller order sizes, companies should strive to reduce the costs of
processes such as setup and order handling so that customer preferences
can be accommodated without raising overall prices. One way to
become more efficient in handling orders is to encourage customers to
access a purchasing web page and place their orders over the Internet.
This would substantially lower the cost of processing large quantities of
small orders. If customers have a preference for suppliers offering high
variety, manufacturing companies can try to customize their products at
the latest possible stage, as well as use information technology to
enhance the linkages from design to manufacturing so that greater
variety and customization can be offered without cost penalties.
(b)
A company might also transform its breakeven or loss customers into
profitable ones by activity-based (menu-based) pricing. This approach
establishes a base price for producing and delivering a standard
quantity for each standard product. In addition to this base price, the
company provides a menu of options, with associated prices, for any
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Atkinson, Solution Manual t/a Management Accounting, 6E
special services requested by the customer. The prices for special
services on the menu can be set simply to recover the activity-based
cost to serve, allowing the customer to choose from the menu the
features and services it wishes while also allowing the company to
recover its cost of providing those features and services to that
customer. Alternatively, the company may choose to earn a margin on
special services by pricing such services above the costs of providing
the service. Pricing surcharges could be imposed when designing and
producing special variants for a customer’s particular needs. Discounts
would be offered when a customer’s ordering pattern lowers the
company’s cost of supplying it.
Activity-based pricing, therefore, prices orders, not products. When
managers base prices on valid cost information, customers shift their
ordering, shipping, and distribution patterns in ways that lower total
supply chain costs to the benefit of both suppliers and customers
(c)
Managing customer relationships provides still another way for a
company to transform its breakeven or loss customers into profitable
ones. For example, companies can persuade their customers to use a
greater scope of the company’s products and services. The margins
from increased purchases contribute to covering customer-related costs
that do not increase proportionately with volume, such as the cost of the
salesperson assigned to the account. Companies can establish minimum
order sizes from unprofitable customers, so that the margins from
higher volumes more than cover the costs of processing an order and
setting up a production run for the customer.
(d)
Finally, companies might transform their breakeven or loss customers
into profitable ones by using their activity-based costing systems to
trace all revenue deductions, as well promotional costs and allowances,
to individual orders and customers in order to calculate actual, realized
profit or loss, customer by customer. This approach should lead to
disciplined discounts and allowances instead of a situation where
companies fail to see all of the revenue leaks from list price because
they record the discounts and allowances in different systems and make
the revenue deductions at different times of the year. Without a
disciplined approach to discounts and allowances, companies might
find that various functional areas (e.g., salespeople, the finance group,
and marketing) independently offer discounts or allowances during the
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Chapter 6: Measuring and Managing Customer Relationships
year, leading to breakeven or loss customers because of the large total
deductions from revenues.
6-21 (a)
Firms may fail to see all of the revenue leaks from list price on orders
because they record the discounts and allowances in different systems
and make the revenue deductions at different times of the year. For
example, the prompt payment discount may be recorded by the finance
department in an aggregate income statement account (sales
deductions); the finance department may lump all freight costs into a
general financial statement account labeled as transportation expenses.
It does not link either the purchase discount or the freight expense back
to a customer or an individual order. The volume discount may be
refunded to the customer only once it has accumulated sufficient
volume to qualify, and it is not linked back to the individual
transactions that qualified for the volume discount. With discounts and
allowances recorded into different accounts and at different times, no
manager sees the complete picture for individual orders and
consequently no one realizes how much revenue loss occurs with
individual orders.
(b)
Once firms become aware of pricing waterfalls leading to undesirably
large sales discounts, they can use their activity-based costing systems
to trace all revenue deductions, as well promotional costs and
allowances, to individual orders and customers in order to calculate
realized profit or loss by order or by customer. Using this information,
companies can periodically (e.g., every quarter) calculate an operating
income statement for every customer. Furthermore, companies can use
the activity-based information on MSDA costs to base salesperson
incentives on order and customer profits, not just sales.
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Atkinson, Solution Manual t/a Management Accounting, 6E
6-22 (a)
If Saunders reduced its sales discounts so that net revenues increased
by 10%, the net revenue would increase to $220,000 and operating
profit would increase by ($70,000 − $50,000)/$50,000 = 40%, as shown
below. Thus, a 10% increase in net sales revenue would result in a 40%
increase in operating profit.
Net sales revenues
Variable costs
Contribution margin
Fixed costs
Operating profit
% change in operating profit
(b)
If sales discounts increased by another 2%, the net revenue would
decrease to $196,000 and operating profit would decrease by ($50,000
− $46,000)/$50,000 = 8%, as shown below. Thus, a 2% decrease in net
sales revenue would result in an 8% decrease in operating profit.
Net sales revenues
Variable costs
Contribution margin
Fixed costs
Operating profit
% change in operating profit
(c)
Initial
$200,000
80,000
120,000
70,000
$50,000
With 10%
Revenue Increase
$220,000
80,000
140,000
70,000
$70,000
40%
Initial
$200,000
80,000
120,000
70,000
$50,000
With 2%
Additional
Discount
$196,000
80,000
116,000
70,000
$46,000
8%
Let x% = the percentage change in net sales revenue. Under the
circumstances in this problem,
Change in operating profit = (Initial revenue × x%)
Percentage change in operating profit =
(Initial revenue × x%)/(Initial operating profit) =
x% × (Initial revenue)/(Initial operating profit)
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Chapter 6: Measuring and Managing Customer Relationships
Thus, the higher the ratio of sales to operating profit, the larger the
change in operating profit in response to a change in x. Equivalently,
the lower the ratio of operating profit to sales, the larger the change in
operating profit in response to a change in x. This implies that the
higher the ratio of operating profit to sales, the smaller the change in
operating profit in response to a change in x.
6-23 (a)
Based on the information given, Donner is more profitable and Carlson
is unprofitable:
Sales
Cost of goods sold
Gross margin
MDSA expenses
Operating profit
(b)
Carlson
$450,000
180,000
270,000
320,000
$−50,000
Donner
$400,000
80,000
320,000
65,000
$255,000
The sum of the commissions is higher for the sales revenue scheme, and
this scheme will encourage salespersons’ efforts to sell to Carlson,
which is unprofitable. The profit scheme will encourage sales efforts to
focus on Donner, which the company prefers because Donner is
profitable and Carlson is not. Moreover, at the stated commission rates,
the company will pay less in commissions with the profit scheme than
under the sales revenue scheme.
Sales
Commission on sales revenue
Total commissions on revenue
Operating profit
Commission on profit
Total commissions on profit
– 207 –
Carlson
$450,000
2%
$9,000
$−50,000
4%
$0
Donner
$400,000
2%
$8,000
$255,000
4%
$10,200
Cost to
Company
$17,000
$10,200
Atkinson, Solution Manual t/a Management Accounting, 6E
6-24 The customer lifetime value, CLV, for Customer 421 is calculated by
summing [(Mt − ct) × (rt)t − 1]/(1 + i)t, where i = the cost of capital, for t = 1,
…, 6 and then subtracting the initial acquisition cost. In this problem, rt = 0.8
each year and i = 0.1. Calculations were performed in Excel and rounded,
leading to the slight discrepancy in the total below.
t
Mt
ct
(rt)t − 1
1 $250 $ 60 1.0
2 300
50 0.8
3 325
50 0.64
4 350
50 0.512
5 375
40 0.4096
6 400
40 0.32768
(1 + i)t [(Mt − ct) × (rt)t − 1]/(1 + i)t
1.1
$172.7273
1.21
165.2893
1.331
132.2314
1.4641
104.9109
1.61051
85.2003
1.771561
66.5881
$726.9472
CLV = $726.95 − $600 = $126.95.
6-25 The net promoter score is the percentage of customers who are promoters
(scores 9 or 10) less the percentage who are detractors (scores 1 through 6).
Thus, the net promoter score = 12.82% + 25.30% − (2.18% + 0.84% + 1.26%
+ 7.14% + 9.86% + 10.96%) = 5.88%.
Score
10
9
8
7
6
5
4
3
2
1
Number of Percentage
Responses
of Total
641
12.82%
1265
25.30%
1254
25.08%
228
4.56%
548
10.96%
493
9.86%
357
7.14%
63
1.26%
42
0.84%
109
2.18%
5,000
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Chapter 6: Measuring and Managing Customer Relationships
PROBLEMS
6-26 This question is designed to generate discussion on what constitutes a desirable
customer. Although a credit customer who charges a large dollar volume and
pays the balance in full on time each month is probably a good credit risk, the
customer is not the most profitable to the credit card issuer. (However, some
credit card issuers may generate indirect additional revenue from such customers
by working with advertisers to selectively add advertising inserts to these
customers.) All credit card purchases generate merchant fees; the credit card
issuer hopes to generate additional income through interest payments and late
fees.
Type 6 is the least desirable type of customer because that type generates no
revenue but causes the issuer to incur costs to send statements. Type 1 is
preferable to Type 6, but less preferable than all the remaining types because
of the short-term, low-interest arrangement. Type 3 is preferable to type 4
because of the late fees, and type 4 is preferred to type 5 because of the higher
balances on which interest is paid. Type 2 is probably less preferred than
types 3 and 4, and possibly type 5. The suggested complete ordering will
depend on the relative dollar magnitudes assumed. A reasonable ordering,
from most preferred to least preferred, is 3, 4, 2, 5, 1, 6.
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Atkinson, Solution Manual t/a Management Accounting, 6E
6-27 (a)
Sales
Less returns
Net sales
Customer Customer Customer Customer
Type 1
Type 2
Type 3
Type 4
$1,000
$1,000
$2,500
$3,000
0
200
500
1,500
$1,000
$800
$2,000
$1,500
Cost of goods sold,
75% of sales
750
600
1,500
1,125
0
30
20
0
Process phone orders,
$80 per hour
20
0
0
80
Process returns,
$5 per item returned
0
20
10
120
4
0
0
48
50
50
50
50
Profit
$176
$100
$420
$77
Profit  Sales
0.18
0.10
0.17
0.03
Processing mail orders,
$5 per nonphone order
Process overnight
delivery requests,
$4 per request
Maintain customer
relations
(b)
Although customer type 4 has the highest sales, it has the highest dollar
returns and the lowest profit. Customer type 3 is by far the most
profitable, even though its sales are less than customer type 4’s (but
customer type 3’s net sales exceed customer 4’s). Customer types 1 and
2 are more profitable than customer type 4 in total dollars and in
percent of sales. Customer type 1 returns the highest profit as a percent
of sales, slightly above customer type 3’s ratio. Cost of goods sold
represents 75% of sales revenue, so the remaining costs as a percent of
sales pertain to each customer’s interaction with the company.
Customer type 4 is the most expensive to service because it orders
frequently, places orders in a costly manner (one hour on the phone),
returns many items, and requests overnight deliveries. Customer type 1
is fairly low-cost to serve in spite of ordering by phone and requesting
overnight delivery because this customer type orders only once a year
and does not return merchandise. Aside from returns, customer types 2
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Chapter 6: Measuring and Managing Customer Relationships
and 3 are fairly low-cost to serve because they order via mail and
request regular delivery rather than overnight delivery.
(c)
Kronecker can seek to reduce the service activity usage or improve
efficiency to reduce the cost of providing services. For example,
Kronecker might ask customers the reason for returns, and follow up
with ways to reduce problems that caused the returns. The company
might also explore ways to make phone ordering more efficient, to
reduce the time spent on the phone. Kronecker may also charge fees to
handle overnight delivery requests.
6-28 Key points in the essay should include the items below. Exercise 6-19
provides a numerical example for developing a whale curve.
 Exhibit 6-2 illustrates an 80-20 graph for sales revenues, with cumulative
percent of products or customers on the x-axis and cumulative percent of
revenue on the y-axis. To prepare such a graph for n products, rank the
products from highest to lowest revenue in spreadsheet column B. In
column A, enter the ranks (integers from 1 to n). Compute the cumulative
percent of products in column C by dividing each product rank by n and
displaying the result in percent format. These percents will be plotted
along the x-axis. Compute the cumulative revenues in column D and
cumulative revenue percentages (divide each entry in column D by the
total of all revenues in column D) in column E. Beginning with the
highest-revenue product, plot the point indicating (Product 1’s percentage
in column C, Product 1’s revenue percentage in column E). Continuing
with the second-highest-revenue product, plot the point indicating (Product
2’s percentage in column C, cumulative percent of revenue for products 1
and 2 in column E). Continue to plot (cumulative percent of products,
cumulative percent of revenue) in this manner until points representing all
the products have been plotted, as in Exhibit 6-2. A graph for customers
would be plotted similarly.
 Typically, companies find that their top-selling 20% of products or
customers generate about 80% of total sales. The lowest volume 40% of
products or customers generates only 1% of total sales.
 Although the 80–20 law applies well to sales revenues, it does not apply to
profits.
 The “In Practice: Building a Whale Curve of Customer Profitability”
describes in detail how to prepare a whale curve with a spreadsheet and
Excel. (Also see Exercise 6-19, which describes adding a starting point of
0.) Briefly, rank the customers from most profitable to least profitable (or
most unprofitable). Beginning with the most profitable customer, plot the
point indicating (Customer 1’s percentage, Customer 1’s percent of total
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Atkinson, Solution Manual t/a Management Accounting, 6E
profit). Continuing with the next most profitable customer, plot the point
indicating (Customer 2’s percentage, cumulative percent of total profit).
Continue to plot (customer percentage, cumulative percent of profit in this
manner until points representing all the customers have been plotted, as in
Exhibit 6-3.
 Exhibit 6-3 provides a typical whale curve of cumulative customer
profitability. The most profitable 20% of customers generated about 180%
of total profits; this is the peak, or hump of the whale above sea level. The
middle 60% of customers approximately break even, and the least
profitable 20% of customers lose 80% of total profits, leaving the company
with its 100% of total profits (“sea level” in the whale curve represents the
company’s actual reported profits). The hump (or maximum height) of a
cumulative profitability curve generally hits 150% to 250% of total profits,
and this height is usually achieved by the most profitable 20% to 40% of
customers.
Customer 1 Customer 2
6-29 (a)
1. Volume discount if 20 or more units
are ordered
2. Pay in full in 15 days
3. Cooperative advertising allowance for
featuring the company’s products in its
advertisements
4. Take a large shipment before the end
of the quarter in advance of an
expected seasonal increase in demand
5. Online ordering discount
6. Rebate on sales during specific
promotional periods
7. Free freight
Total
2%
3%
2%
4%
4%
5%
2%
2%
2%
3%
21%
8%
(b) Randolph Company’s management may have been unaware of
the potentially large discounts offered to its customers because
the discounts and allowances arise from different sources and
are recorded in different systems. In addition, the revenue
deductions may occur at various times of the year. For example,
the prompt payment discount may be recorded by the finance
department in an aggregate income statement account (sales
deductions); the finance department may lumps all freight costs
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Chapter 6: Measuring and Managing Customer Relationships
into a general financial statement account labeled as
transportation expenses. The marketing department may initiate
the cooperative advertising allowance, volume discount
allowance, and rebates. With discounts and allowances
recorded into different accounts and at different times, no
manager sees the complete picture for individual orders and
consequently no one realizes how much revenue loss occurs
with individual orders.
(c)
Once firms become aware of pricing waterfalls leading to undesirably
large sales discounts, they can use their activity-based costing systems
to trace all revenue deductions, as well promotional costs and
allowances, to individual orders and customers in order to calculate
realized profit or loss by order or by customer. Using this information,
companies can periodically (e.g., every quarter) calculate an operating
income statement for every customer. Furthermore, companies can use
the activity-based information on MSDA costs to base salesperson
incentives on order and customer profits, not just sales. Randolph
Company can also evaluate whether it wants to continue offering free
freight to Customer 1.
6-30 (a)
CLV
Customer 1
$42.47
Customer 2
−$253.94
Customer 3 Customer 4
−$129.14
$27.73
Supporting calculations appear below. The customer lifetime value,
CLV, is calculated by summing [(Mt − ct) × (rt)t − 1]/(1 + i)t across each
of the t years retained, where i = the cost of capital, and then
subtracting the initial acquisition cost. In this problem, i = 0.1.
Calculations were performed in Excel and rounded, leading to the slight
discrepancy in the total.
Customer 1:
t
Mt
ct
1 $275 $0
2 275
0
3 275
0
4 275
0
5 275
0
(rt)t − 1
1
1
1
1
1
(1 + i)t [(Mt − ct) × (rt)t − 1]/(1 + i)t
1.1
$ 250.00
1.21
227.27
1.331
206.61
1.4641
187.83
1.6105
170.75
$1,042.47
CLV = $1,042.47− $1,000 = $42.47
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Atkinson, Solution Manual t/a Management Accounting, 6E
Customer 2:
t
Mt
ct
1 $300 $0
2 300
0
3 300
0
(rt)t − 1
(1 + i)t [(Mt − ct) × (rt)t − 1]/(1 + i)t
1
1.1
$272.73
1
1.21
247.93
1
1.331
225.39
$746.06
CLV = $746.06 − $1,000 = −$253.94
Customer 3:
t
Mt
ct
1 $275 $0
2 275
0
3 275
0
4 275
0
5 275
0
(rt)t − 1
1.0
0.9
0.81
0.729
0.6561
Customer 4:
t
Mt
ct
1 $275 $50
2 275 25
3 300
0
4 300
0
5 300
0
(rt)t − 1
1
1
1
1
1
(1 + i)t [(Mt − ct) × (rt)t − 1]/(1 + i)t
1.1
$250.00
1.21
204.55
1.331
167.36
1.4641
136.93
1.6105
112.03
$870.86
CLV = $870.86 − $1,000 = −$129.14
(1 + i)t [(Mt − ct) × (rt)t − 1]/(1 + i)t
1.1
$ 204.55
1.21
206.61
1.331
225.39
1.4641
204.90
1.6105
186.28
$1,027.73
CLV = $1,027.73 − $1,000 = $27.73
(b)
Comparing Customer 1 to Customer 2, even though Customer 1’s net
margins (margins minus costs to serve) per year are smaller, the longer
time period more than compensates for the smaller net margins,
yielding a larger CLV. Contrasting Customer 1 and Customer 3, we see
the importance of retention. A slight decrease in the retention rate
changes the CLV from positive to negative. In comparing Customer 4
to Customers 1 and 3, note that Customer 4 has same total (M − c) as
Customers 1 and 3. The additional cost to serve and retain Customer 4
in years 1 and 2 provides net benefits in the form of higher margins in
later periods, yielding a positive CLV that is only slightly lower than
Customer 1’s. Contrasting Customer 3 and Customer 4 again illustrates
the importance of the retention rate. The additional cost to serve and
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Chapter 6: Measuring and Managing Customer Relationships
retain Customer 4 in years 1 and 2 provides net benefits and helps
create the difference between a positive CLV for Customer 4 and a
negative CLV for Customer 3.
(c)
Assuming that n is very large and the numbers in the table remain about
the same each year, the infinite horizon CLV is (M − c)/(i + [1 − r])
minus the acquisition cost.
Customer
1
2
3
(d)
(M − c)/(i + [1 − r])
Acquisition
Cost
$2,750
3,000
1,375
$1,000
1,000
1,000
CLV
$1,750
2,000
375
Companies can use the information gathered to calculate customers’
estimated lifetime value to target customers with high expected lifetime
value. The critical parameters for calculating lifetime customer value
are
 Initial acquisition cost
 Profits or losses earned year
 Any additional costs incurred to retain the customer each year
 The duration of the relationship
Some companies have highly sophisticated analytic systems that allow
them to estimate these parameters based on the demographic
characteristics of a potential or newly-acquired customer. The analytics
help guide the companies’ promotion strategies and campaigns to
attract customers with the highest expected lifetime value. For example,
RBC Financial Group in Canada uses an analytic model of a customer’s
future profitability based on age, tenure with the bank, number of
products and services already used at the bank, and the customer’s
potential to purchase additional products and services, grow account
balances, and generate fee-based income.1 The bank assigns a personal
account representative to its estimated high lifetime value customers,
ensures that their phone calls get picked up quickly, and provides them
with ready access to credit at attractive terms.
V. G. Narayanan, “Customer Profitability and Customer Relationship Management at RBC
Financial Group,” HBS Case # 102-043.
1
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Atkinson, Solution Manual t/a Management Accounting, 6E
6-31 The net promoter score is likely to have the greatest predictive power for repeat
purchases and growth in business-to-customer settings where customers have
frequent interactions with companies. The score is likely to have the least
predictive power in business-to-business settings where purchasing decisions are
made by highly sophisticated professionals. In this case, it is better to ask, “How
likely is it that you will continue to purchases products or services from Company
X?”
CASES
6-32 The responses below are based on “Survival Strategies: After Cost Cutting,
Companies Turn Toward Price Increases,” by Timothy Aeppel, The Wall
Street Journal (September 18, 2002, p. A1).
(a)
Jergens’ president based the price on what he determined to be the cost
of producing the order of 10 odd-sized fasteners from scratch. The cost
included setup for the odd size and overtime labor. The company
actually produced the odd-sized fasteners by producing full-size
fasteners and then shortening 10. This method was less costly than
setting up the equipment to run a small batch of the required odd size.
(b)
Goodyear had been rewarding its sales force based on volume,
providing an incentive for the sales force to deeply discount prices to
large distributors. The discounts were so substantial that the large
distributors could resell the tires to smaller distributors (even with
transportation costs to other regions), reducing Goodyear’s sales at
higher prices to smaller distributors. Goodyear responded by cutting the
discounts to large distributors, removing discount approval authority
from the sales force and transferring it to a “tactical pricing group” that
determines whether Goodyear can profitably match a competitor’s
prices. Goodyear also modified its sales force bonus scheme to include
a “revenue per tire” metric.
(c)
Emerson discovered that customers were willing to pay about 20%
more than Emerson’s initially proposed cost-based price of $2,650 for a
new compact sensor. Emerson priced the sensor at $3,150. Note that the
article does not provide information on how Emerson determined
product costs that it used as a basis for its markups. A traditional cost
system is more likely to undercost a low-volume or customized product
because it allocates manufacturing support costs to products based on
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Chapter 6: Measuring and Managing Customer Relationships
unit-level drivers. An activity-based costing system more accurately
assigns costs based on resource usage.
(d)
Wildeck, “a maker of metal guard rails, mezzanines and material lifts
for factories and warehouses,” promoted packages that included
installing its products. The installations bring higher profit than parts
catalog sales. Wildeck responded to a competitor’s lower-priced
storage-rack protector by developing its own “lite” version and pricing
it much lower than the competitor’s price. When customers called about
purchasing the lite version, they were informed of the benefits of the
original version, and most of these customers bought the original
version. An accurate costing system, such as a good activity-based
costing system that includes both manufacturing and nonmanufacturing
costs of providing goods and services to customers, provides
reasonably precise information to managers for making decisions about
the mix of products and services to offer to customers and prices to
charge in order to generate the desired level of profitability.
(e)
Union Pacific introduced a minimum price that was higher than a third
of its customers paid. The company was not concerned if it lost these
customers because customers who were paying higher prices would fill
up the newly free space. Dropping unprofitable customers will not lead
to an immediate increase in profit if the associated capacity-related
costs are committed costs and the resources cannot be put to other
profitable use.
6-33 Midwest Office Products2 (HBS Case 9-104-073)
Midwest is a revised version of Dakota Office Products (HBS Case No.
102-021), designed to introduce students to time-driven activity-based
costing. Midwest is a constructed example, but one based on the actual
experiences of several medical distribution and office products companies. It
simplifies many of the complex processes that would arise in an actual
application, but the simplification enables students to construct a time-driven
ABC model for Midwest in a relatively short amount of time. Instructors can
2 Copyright © 2005 by the President and Fellows of Harvard College. Harvard Business
School Teaching Note 5-105-084. This teaching note was prepared by Professor Robert S.
Kaplan as an aid to instructors in the classroom use of the “Midwest Office Products” case,
HBS No. 104-073. Reprinted by permission of Harvard Business School. The teaching
notes have been adapted for use with the textbook.
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Atkinson, Solution Manual t/a Management Accounting, 6E
discuss with the class how to extend the model to capture more complex and
realistic situations. The costing of five representative orders gives students
insights about the power and management implications of the approach.
The case is simple enough that it can be used as a first activity-based
costing case. Given that the time-driven approach is both simpler and more
powerful than original ABC, I now prefer to introduce students directly to this
approach, rather than introduce ABC in its original form, and then migrate
them to the time-driven approach.
Teaching Objectives
Introduce students to time-driven activity-based costing through a
simplified numerical exercise based on actual company situations. Enable
students to propose actions that would transform unprofitable orders and
customers into profitable ones.
Assignment (for the standalone case)
Read
“Time-Driven Activity-Based Costing”
#R0411J
“Activity-Based Costing and Capacity”
Optional: ABC Pen Factory Tutorial
Harvard Business Review reprint
HBS No. 105-059
HBS No. 103-704
The Kaplan–Anderson Harvard Business Review article on Time-Driven
ABC (#R0411) should be sufficient to introduce students to ABC even if they
have not previously studied the subject. Should instructors want a more
comprehensive introduction to “original” ABC, they can consider: R.S.
Kaplan, “Introduction to Activity-Based Costing,” HBS Note No. 197-076
(Boston: Harvard Business School Publishing, 1997).
The technical note on ABC and capacity can be optional or background
reading. It helps students understand why ABC cost driver rates should be
based on practical capacity, not actual utilization. This may shorten discussion
that otherwise arises in class about what happens to cost driver rates after
order mix changes and process efficiencies reduce the demand on
organizational resources. The ABC Pen Factory Tutorial provides an on-line
demonstration of why companies can benefit from ABC. It shows how ABC
captures cost behavior better than traditional, volume-based costing.
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Chapter 6: Measuring and Managing Customer Relationships
Textbook Assignment Questions (adapted from the original case questions):
(a) Based on the interviews and data in the case, estimate:
(1)
(2)
(3)
(4)
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
(b) Using this capacity cost rate information, calculate the cost and profitability
of the five orders in Exhibit 6-10. What explains the variation in
profitability across the five orders?
(c) On the basis of your analysis, what actions should John Malone take to
improve Midwest’s profitability? Include suggestions for managing
customer profitability.
(d) Suppose that currently, Midwest processes 40,000 manual orders per year,
with a total of 200,000 line items to enter, and processes 30,000 electronic
orders.
i.
How much unused practical capacity does the company have?
ii.
If the company’s efforts to encourage customers who order manually to
change to electronic ordering results in 20,000 manual orders per year,
100,000 line items to enter, and 50,000 electronic orders, how many
order entry operators will the company require? If order entry resource
costs can be reduced in proportion to the number of employees, what
will be the cost savings from the changes?
iii.
Returning to the original information in (d), if the company’s process
improvement efforts result in a 20% reduction in time to perform each
of the three order entry activities, how many order entry operators will
the company require? If order entry resource costs can be reduced in
proportion to the number of employees, what will be the cost savings
from the process improvements?
Discussion
Introductory Remarks
If this is the students or executives’ first exposure to activity-based costing, I
often start with the data in TN Exhibit 6-1, taken from a company I consulted
with in 1995. While flying to the company, I thought about how to motivate the
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Atkinson, Solution Manual t/a Management Accounting, 6E
discussion with the senior executive team about whether to adopt activity-based
costing. In reading the company’s annual report, I saw the 10-year summary,
which I have excerpted in TN Exhibit 6-1. During the past ten years, the
company was fortunate to have had a sales increase of nearly 135%, as sales had
increased from $2.08 billion to $4.89 billion. Conventional cost accounting
thinking focuses on distinguishing between fixed and variable costs. If this
company had any significant fixed costs during a period when sales increased by
135%, the company’s main problem would be the frequency with which it would
have to deposit cash into its bank accounts. But as the study of cost of goods
sold and gross margin revealed, the CGS—rather than decreasing as a
percentage of sales, as it would have to if any fixed costs existed—actually
increased as a percentage of sales. So not only were CGS not fixed, they were
not even variable (that would have produced a constant gross margin
percentage). In fact, the CGS were super-variable costs, rising faster than sales.
A similar result was found in “below the gross margin line” costs—selling,
general, and administrative costs. Despite many accountants treating these as
“fixed costs,” these SG&A costs were also super-variable, increasing faster than
sales. These finding set the stage for the ABC cost model, trying to understand
why companies, operating with a traditional volume-based cost system, typically
increase their sales by offering more variety, features, and service, leading to
costs rising faster than sales. An ABC model helps a company identify when it
has not recovered all the incremental costs associated with an order that has
special features, such as small order quantities, expedited ordering, and
customized delivery options.
Analysis
Q: What are the operating processes at Midwest Office Products?
I try to get the students help me get the simple process flow model below on the
top of the board:
Process
Receive and Store
Process
Variety
none
Enter Customer
Orders
manual or electronic
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Distribute
or Ship
commercial or desktop
Chapter 6: Measuring and Managing Customer Relationships
Students may also comment on the differential lengths of time that customers
take to pay.
I then describe how to build an ABC model for the three processes performed by
Midwest:
Step 1:
Step 2:
Step 3:
Step 4:
Assign costs to processes
Calculate practical capacity of processes
Calculate cost rate of supplying capacity
Assign costs to orders or products based on their use of capacity
I start with the warehouse process to receive and store a carton:
(a) (1)
Q: What does it cost to process a carton through the distribution center?
The cost of the warehouse personnel is calculated by subtracting the cost of the
delivery personnel (not involved with warehouse operations) from the total
distribution center personnel cost. To this cost must be added the cost of
operating the warehouse.
1. Cost of process:
$2,320,000 + 2,000,000 =
$4,320,000
2. Practical capacity
 80,000 cartons
3. Cost rate for supplying capacity
= $54 per carton
You should ask what assumption is made by this calculation. The answer, of
course, is that all cartons place the same demands on warehouse resources. The
follow up question, therefore, is when would this assumption be violated? The
hoped-for responses are:
1. Cartons can be of varying size, and therefore occupy differential amounts
of space
2. Cartons can stay in storage for varying amounts of time, consuming
differential quantities of days of cubic storage space
3. Cartons can require different quantities of time by warehouse personnel to
process; as a specific example, a customer order may ask for a less than
carton quantity to be shipped. In this case, a warehouse person has to break
open the carton, pick the desired quantity of materials, and then package
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Atkinson, Solution Manual t/a Management Accounting, 6E
them up to be shipped to the customer. Such breakpack quantities are far
more expensive to process per unit than carton-sized quantities.
All of these complexities can be handled by a slightly more complex ABC
model. The analyst could treat the warehousing function as consisting of two
sub-processes, one for supplying space (cost per cubic meter per day) and one for
supplying warehouse personnel time (cost per hour). In this way, products that
take up much space and stay in storage longer will have higher costs assigned to
them than products packaged in small cartons that turn over quickly in the
warehouse. Similarly, breakpack quantities will have more costs assigned to them
than standard, carton-sized quantities. To introduce such complexity into the case
would lead to students (and the instructor) spending more time building the
model, which is why I did not incorporate them. But the instructor should point
out how the cost model could be easily expanded to incorporate these more
realistic situations, as long as the company had data on carton size, productspecific turnover rates, and actual quantities ordered—as it almost always would.
Q: What else is missing from the calculation of warehousing cost?
We do not have enough information to assign some general and administrative
costs related to warehouse personnel. General and selling (G&S) costs are
reported as a single line item in the income statement, and the project team did
not collect information about how these might be traced to order handling costs.
This was a deliberate omission in the case. Some students will allocate these
costs as a percentage markup over the $54 per carton warehouse processing
costs. I then question the rationale for such a procedure, asking them what
assumption this allocation method makes. The answer is an assumption that G&S
costs are proportional to warehouse processing costs, which they almost surely
are not. I try to get the class to understand that using percentage markups to
allocate indirect and support costs is indefensible. The percentages bear no causal
relationship back to the cost incurrence. If instructors follow Midwest Office
Products with a case on customer profitability, they can point out that some G&S
costs relate to customers not to processing orders, and that this cost assignment
will be discussed in a subsequent case.
The instructor has the option to give a little lecturette at this point, pointing out
that a more complete costing model would perform an ABC analysis for each
component of G&S expenses—such as human resources, finance, and
information technology costs—so that the costs of these departments can be more
accurately driven directly to processes based on the demands that the processes
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Chapter 6: Measuring and Managing Customer Relationships
make on each of the corporate support departments. The instructor can go back to
an example reported by Tom Johnson of how Weyerhaeuser assigned its
corporate support departments to its business units using cost drivers, not
percentages.3
(a) (2)
Customer Order Entry
Having explored approaches for driving warehousing costs to orders, the
instructor can now turn to estimating order entry costs. Again the four-part
numerical sequence should be straightforward to elicit from the class:
Calculate cost per hour for the resources doing the order entry
1. Cost of resources performing order entry
$840,000
2. Capacity of order entry resources: 16  1,500 hours = 24,000
3. Cost of order entry process
$35/hour (or $0.583/minute)
4. Assign costs based on use of resources
Entering a manual customer order:0.150  35 = $5.25/manual order
Entering a line item on order
0.075  35 = 2.625/line item
Validating an EDI order
0.100  35 = 3.50/EDI order
As with the previous discussion (on warehousing costs), the instructor can ask
the class about what assumptions are being made by the above calculation.
Again, G&S costs are excluded because we don’t have sufficient information to
assign them analytically. The core assumption is that all electronic orders take
the same amount of time to validate or verify, and all manual orders take the
same amount of time to enter the basic information, independent of the
complexity of the order (other than the number of line items in a manual order).
More realistically, some orders may be more complex to handle: expedited
orders, orders requiring special packaging or delivery instructions, and, in
general (beyond the Midwest case example), international orders, orders of
fragile items, etc. This is a good time to review the concept of time equations,
H.T. Johnson and D.A. Loewe, “How Weyerhaeuser Manages Corporate Over head Cost,”
Management Accounting, August 1987, pp. 20–26.
3
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Atkinson, Solution Manual t/a Management Accounting, 6E
discussed in Chapter 5 and the Kaplan-Anderson HBR article, as an easy and
effective tool for handling order complexity. TN Exhibit 6-2 shows a slide that
can be used to illustrate time equations. Emphasize with the class that this type of
complexity was suppressed in the Midwest case to reduce class preparation time.
The other important point to be made about time equations is that the information
on order characteristics is generally available from the company’s ERP or
automated order entry system, so that each order can be individually costed based
on its specific characteristics. This feature enables time-driven ABC to
incorporate far more process complexity and diversity than original ABC, which
would require separate activity pools to be set up to handle each major variation
in order diversity and complexity.
If time permits the instructor can also work with the class to learn how to
update the time-driven ABC model: This material is optional to cover, especially
in a 75-minute class.
Q: What causes a cost rate ($/hour) or unit time estimate to change?
Suppose through a business process improvement (such as TQM, or 6 sigma),
Midwest improves the process so that manual customer orders can be handled
20% faster. It can then just reduce the unit time estimate by 20% putting 0.15 ×
(1 −.20) = 0.12 into the ABC program or Excel spreadsheet.
If Midwest grants its order entry clerks a 6% raise, modify the resource cost
and re-estimate the cost per hour (from $35/hour to $37.10/hour). Similarly, if
Midwest grants them an extra holiday or vacation day, reduce the practical
capacity of these resources, and recalculate the cost per available hour. Students
should see how simple it is to keep a time-driven ABC model current, by
modifying hourly cost and unit time estimates based on known shifts in the
process.
The class can now turn to costing the third major process, distributing orders
to customers. The instructor can ask:
(a) (3)
Q: What does it cost to ship a carton using commercial delivery?
The four-step calculation is simple to perform:
1. Cost of resources for commercial shipments
2. Quantity of cartons shipped
3. and 4. Calculate shipping cost per carton
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$450,000
 75,000
= $ 6/carton
Chapter 6: Measuring and Managing Customer Relationships
Midwest has outsourced its standard shipping arrangements (rather than
performing this process with internal resources). Therefore, the unit cost does not
involve calculating a cost of supplying capacity to perform this process.
The case example was simplified to assume an identical cost for each carton
shipped. In general you could direct charge the actual shipping expense to each
order without much difficulty by linking the shipping invoice to the order. If you
had different shipping arrangements—expedite, prepare for overseas shipment,
special handling—you would again estimate specific times using time equations.
Having calculated the unit cost for commercial shipments, the class can now
perform the final cost estimate, for distributing cartons directly to the customer’s
location.
(a) (4)
Q: How much does a desktop delivery cost?
1. Cost of desktop delivery resources: $200,000 + 250,000 = $450,000
2. Number of hours available for DD = 4 × 1,500
 6,000
3. Cost rate for desktop delivery
= $75/hour
Students may propose two alternative methods for calculating the cost of
desktop deliveries. One option, based on an original ABC calculation, assumes
an identical cost per carton for desktop delivery:
$450,000/2,000 DD’s = $225 per DD
The error in this calculation is that it doesn’t allow for variation in desktop
deliveries, some may be close others may be far away. Also, some cartons may be
part of a large order delivered to a customer location, while others may be for a
sole delivery of a carton. The actual delivery cost varies by number of deliveries,
not the number of cartons in a delivery. Thus the original ABC calculation above
contains two sources of error.
The other method estimates a standard cost per delivery. This allows number
of deliveries rather than number of cartons to be the cost driver. With 2,000
deliveries, the standard cost is $225 per delivery. While this calculation avoids
the second problem above, it still assumes that all deliveries are equally costly,
thereby suppressing the different costs associated with delivering to nearby
versus distant customers. The preferred procedure, which is both accurate and
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Atkinson, Solution Manual t/a Management Accounting, 6E
simple to implement, is to use the $75 per hour costing rate, and calculate the
time required for each delivery. You can point out that today’s technology and
information systems (such as GPS to track trucks in real time and hand-held
computers that truck drivers can use to log in upon arrival and departure at a
customer’s location) enable Midwest to use cost drivers that are more specific
and accurate for individual customers, rather than averages! In general, Midwest
could even track the time used at the customer’s site if it had to deliver to
multiple locations.
At Kemp’s, the dairy company described in the sidebar of the assigned HBR
article, drivers have computer entry device in their trucks. They record when
leaving a company’s warehouse, when they arrive at the next site, and when they
leave that site. The data are automatically uploaded to Kemp’s ERP and costing
system.
For desktop deliveries, orders are costed only for the capacity they use.
Suppose the same $450,000 of resources for desktop delivery were supplied
during the year but only 1,500 desktop deliveries were made. Then the traditional
cost per DD would have been calculated at $300 per direct delivery, not the $225
previously calculated. So the cost assigned fluctuates with capacity utilization,
which is not a good idea. With the time-driven approach, the cost rate
automatically stays at $75/hour and orders are charged only for the hours they
use. The cost of unused capacity is reported each month—for management
attention. This is subject of the technical note, which can be assigned as optional
reading for the class.
At this point, the instructor can step back from the calculation details to get the
class focused on the big picture, about when and why companies benefit from
having a more accurate costing system.
Q: When is it worth tracking this much detail to customer orders (the cost of
processes and the unit times used on the process by various orders or
deliveries)?
1. The Willie Sutton rule:4 Look for areas with large expenses in
indirect and support resources, especially where such expenses
Willie Sutton was a successful bank robber in the United States during the 1950s. Willie, who
was eventually captured at his home not far from a local police station, was asked during his initial
interrogation, “Why do you rob banks?” Willie replied, with the wisdom that had made him
4
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Chapter 6: Measuring and Managing Customer Relationships
have been growing over time. Operations where almost all
expenses are direct labor and direct materials, which can
already be directly traced to individual products by traditional
costing systems, may have less need for ABC systems.
2. High Diversity rule: Look for a situation in which large variety
exists in products, customers, or processes. For example,
consider a facility that produces mature and newly introduced
products, standard and custom products, and high-volume and
low-volume products. For marketing and selling expenses,
companies may have a mixture of customers who order highvolume, standard products with few special demands as well as
customers who order in small volumes, special products, and
require large quantities of pre-sales and post-sales technical
support.
(b) and (c)
We are finally ready to cost the five orders. I recommend having a student
estimate the cost for Order 1 and Order 2 and then hand out TN Exhibit 6-3,
which contains the proposed solution, based on the model cost estimates
Order 1 and Order 2 seem identical, except that the price for Order 2 is 4%
higher because it involves direct delivery. Thus Order 2’s gross margin is
substantially higher than for Order 1. Companies operating with a traditional or
contribution margin costing system will celebrate the success of their direct
delivery option. But the ABC analysis reveals that Order 2 requires far more
resources to fulfill, involving $300 of delivery resources, $4.38 more in order
entry resources (because of manual order entry), and nearly $20 more in finance
charges because of its long collection period. So rather than being the more
profitable order, Order 2 has a profit margin of minus 40%, compared to the
attractive positive 6.6% net margin from Order 1.
One can go into more detail by showing that the customer has willingly paid
$24 extra for the direct delivery option, but Midwest has incurred $294 in higher
delivery costs to offer this option. Direct delivery is part of Midwest’s
successful for many years, “That’s where the money is!” When developing ABC systems, we
should follow Willie’s sage advice (but not his particular application of the insight) to focus on
high cost areas where improvements in visibility and action could produce major benefits to the
organization. Applying an ABC analysis to a set of resource expenses that are below 1% of total
spending will not lead to high payoffs to the organization.
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Atkinson, Solution Manual t/a Management Accounting, 6E
differentiating strategy, to develop more sales and higher customer loyalty by
offering additional features and service that the customer values (and is willing to
pay more for). But a differentiation strategy is only successful if the value created
by the differentiation (the $24 price premium) exceeds the company’s cost ($300)
for providing the differentiating service. In this case, the differentiation strategy
is a quite spectacular failure, at least for single carton deliveries.
Orders 3 and 4 are the same as Orders 1 and 2 except that they are scaled by a
factor of 10. Order 4 now makes a positive profit contribution and it is breaking
even on its direct delivery service; the incremental revenues of $24 per carton
now generate $240 of additional revenues, which equals the incremental costs of
$240 ($300 – $60) for direct versus commercial delivery of the cartons. Also, by
paying in 120 days, rather than 30 days, its financing costs are nearly $200 higher
than for Order 3. In addition, manual ordering costs decrease profits. So even
with the higher scale of operations, with a gross margin $240 higher than for
Order 3, Order 4 has less than half the profit margin of Order 3.
Order 5 illustrates the impact of the hidden costs associated with manual
order entry and long payment terms. It is the same as Order 3, except for manual
versus electronic ordering and payment in 120 rather than 30 days. These
seemingly innocuous changes reduce the profit margin by nearly 50%, a very
important issue for companies with small operating margins.
Q: What do you suggest Midwest should do, based on its new cost estimates?
I recommend grouping the recommendations under the three columns, shown
below, without necessarily labeling the columns as you accept suggestions from
the class.
Order
Acceptance/Modify
Customer
Process Improve
Pricing
Relationships
Route optimization
Specific charges for DD Reject small orders;
based on number of
establish minimum order
drop points, distance
size
(time) traveled
Migrate customers to
more efficient channels
(EDI)
Discounts for EDI
orders
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Limit distances for DD
Chapter 6: Measuring and Managing Customer Relationships
Improve efficiency of
warehouse operations,
and order entry process
Menu-based pricing
Standard delivery,
packaging
Customer picks up at
warehouse; price
quoted FOB
Q: Suppose customers all switch to EDI orders; no price discounts, get same
quantity and mix of orders? How does this affect Midwest’s profits next
year?
Certainly, the cost of processing orders goes down, and many more orders will
be profitable. But Midwest still loses the same $80,000 in the year. How can this
be?
Process efficiencies or shifting customers to lower cost channels, reduces the
demands made on the organization’s resources, in this case – the order handling
people. But until action is taken to redeploy or reduce the supply of these
resources, Midwest keeps paying for them! The actions in the table above will
create UNUSED CAPACITY. Management must act to exploit this unused
capacity.
Q: A similar question to the one above is, “What if Midwest eliminates 30K of
Type 2 orders because they are unprofitable, but doesn’t get any new
orders to replace them”
The naïve model, based on actual capacity utilization would re-calculate
the per carton warehouse processing cost as
Warehouse processing cost = $4,320,000/50K = $86.40/order
The risk to Midwest is it now starts to drop Type 4 and Type 5 orders
leading to a death spiral. This is why resources should be costed at
practical capacity, not actual utilization. It is better to keep the
warehousing cost rate at $54 per carton and report 30K × $54 = $1,620K
as unused capacity.
You can close the class by pointing out the next steps in extending the ABC
analysis beyond the accurate costing of individual orders:
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Atkinson, Solution Manual t/a Management Accounting, 6E
 Analyze and assign general and selling costs
 Drive selling and order costs to customer; calculate cost-to-serve
individual customers
 Customer profitability: aggregate all orders by individual customers
(d)
i. Using the order entry times stated in part (a) (2), if Midwest processes
40,000 manual orders per year, with a total of 200,000 line items to
enter, and processes 30,000 electronic orders, then Midwest requires
(40,000 × 0.15) + (200,000 × 0.075) + (30,000 × 0.1) = 24,000 hours
per year, which equals the current practical capacity. Therefore, the
company needs all 16 operators and there is no unused capacity.
ii. Midwest will require (20,000 × 0.15) + (100,000 × 0.075) + (50,000 ×
0.1) = 15,500 hours per year, which requires 10.33 operators. The cost
per operator is $840,000/16 = $52,500. If order entry costs can be
reduced in proportion to the number of employees, the cost savings will
be $52,500 × (16 −10.33) = $297,500. If Midwest only hires full-time
employees, it will need 11 operators and the cost savings will be
$52,500 × (16 −11) = $262,500.
iii. Midwest will require (40,000 × 0.12) + (200,000 × 0.06) + (30,000 ×
0.08) = 19,200 hours per year, which requires 12.8 operators. If order
entry costs can be reduced in proportion to the number of employees,
the cost savings will be $52,500 × (16 − 12.8) = $168,000. If Midwest
only hires full-time employees, it will need 13 operators and the cost
savings will be $52,500 × (16 −13) = $157,500.
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Chapter 6: Measuring and Managing Customer Relationships
TN Exhibit 6-1 Super-Variable Costs, Profitability Declines with Growth
GROWTH COMPANY SALES AND PROFIT SUMMARY, 1985–1994
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
Sales
Gross profit
Margin
$4,889
$950
19.4%
$4,388
$870
19.8%
$4,193
$818
19.5%
$3,915
$727
18.6%
$3,498
$689
19.7%
$3,122
$626
20.1%
$2,878
$584
20.3%
$2,483
$508
20.5%
$2,234
$457
20.5%
$2,083
$432
20.7%
S & A expense
S&A%
$491
10.0%
$454
10.3%
$412
9.8%
$364
9.3%
$327
9.3%
$293
9.4%
$271
9.4%
$229
9.2%
$206
9.2%
$196
9.4%
157
141
134
125
112
100
92
80
72
67
168
155
141
124
112
100
92
78
70
67
Sales (1989 = 100)
S&A expense
(1989=100)
Source: Robert S. Kaplan
TN Exhibit 6-2 Time-Driven ABC Incorporates Variety and Complexity by Use
of Time Equations
Customer Service Time = 6 minutes
+ 3 minutes for special orders
+ 5 minutes if credit memo required
– 2 minutes if electronic order
+ 4 minutes if Customer xyz
– 1.5 minutes if Customer pqr
…
…
Data about specific order characteristics for time equations
come automatically from company’s ERP and CRM systems.
Source: Robert S. Kaplan
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Atkinson, Solution Manual t/a Management Accounting, 6E
TN Exhibit 6-3 Five Order Profitability
Sales
Cost of items purchased
Gross margin
Processing cartons
Shipping cartons, commercial
Desktop deliveries
Process manual order
Process line items, manual
orders
Validate EDI order
Interest on receivable
Total processing costs
Order profitability
Return on sales
Source:
1
2
3
4
5
$610.00
500.00
$110.00
54.00
6.00
0.00
0.00
0.00
$634.00
500.00
$134.00
54.00
0.00
300.00
5.25
2.63
$6,100.00
5,000.00
$1,100.00
540.00
60.00
0.00
0.00
0.00
$6,340.00
5,000.00
$1,340.00
540.00
0.00
300.00
5.25
26.25
$6,100.00
5,000.00
$1,100.00
540.00
60.00
0.00
5.25
26.25
3.50
0.00
61.00
253.60
$ 664.50 $1,125.10
$ 435.50 $ 214.90
7.1%
3.4%
0.00
244.00
$ 875.50
$ 224.50
3.7%
3.50
0.00
6.10
25.36
$ 69.60
$387.24
$ 40.40 ($253.24)
6.6%
-39.9%
Robert S. Kaplan
– 232 –