To: Mr. John Malone, GM of Allied Office Products
Subject: Evaluating TFC's costing system to create a more profitable branch
Executive Summary - Allied Office Products
Increased competition in the forms manufacturing business motivates companies to create ways to increase sales and maximize profits. As a corporation in the forms manufacturing business, Allied Office Products strives to develop, create, and offer new value-adding services to its clients in order to differentiate itself from competitors. In 1988, the company expanded into the business forms inventory service line. This new line of service was offered through the Total Forms Control (TFC) branch. Four years later, TFC achieved sales of $60 million. Its services focused primarily on: warehousing, form distribution, inventory control, and form usage reporting. Although the branch is growing and TFC's return on investment is six percent, the Business Forms Division's return on investment is twenty percent. Thus, TFC’s return on investment seems to be less than exceptional.
Upon the realization of the company's short comings, upper management has turned to TFC Controller, Melissa Dunhill, and Director of Operations, Tim Cunningham, to assist in upper management understanding customer profitability. Currently, the company uses a normal cost system. Normal cost systems apply direct materials and direct labor and then apply predetermined overhead rates in determining costs of activities. (Hansen & Mowen, 2013) In exhibit 1 of the case, the calculation for the predetermined overhead rate displays how product sales at cost are used as the cost driver and the overhead accounts are broken down into percentages of sales at cost. Cost drivers are factors that measure the demands placed on an activity. (Hansen & Mowen, 2013) With the current strategy, the standard price for the product services is the same no matter the level of services required. Although this approach does allocate the expenses to the clients, it does not result in an effective pricing strategy or a fair profitability per client analysis.
With the objective of raising the profit margin, many companies are switching to Activity Based Costing (ABC) systems. ABC systems trace costs to particular activities and then trace these activities to the products/services offered. (Hansen & Mowen, 2013) If Allied could utilize an ABC system for its TFC department, then clients could be charged by both the services rendered and the product costs. This would result in better pricing strategies and expense allocation for the company overall. To obtain the primary activities and the associated cost drivers for each activity, upper management visited the distribution center and interviewed warehouse supervisor, Rick Fosmire, and data entry operator, Hazel Nutley. After gathering data, a conclusion was made that it is not fair for clients with similar sales amounts to be charged the same amount of money regardless of the level of services obtained. It was also determined that this is the primary area of responsibility for profitability issues. Upon these conclusions, upper management contacted our team to help with the cost system issues of TFC. By examining the information discovered from onsite observations and the costing systems currently in place, the purpose of this analysis is to examine whether or not an ABC costing system would result in effectively allocating expenses; thus, resulting in improved pricing methods that would in return raise company profits.
ABC System Analysis
When constructing an ABC system, the first task is to identify the activities. From the interviews and observations that were completed, upper management disclosed six primary value adding activities including: storage, requisition handling, basic warehouse stock selection, “pick-pack” activity, data entry, and desk top delivery. Additional costs relating to clients include: freight out,...