Activity-Based Costing Case Questions
Case Questions
Carefully study the Saharis.cz case and upload a memo with answers to all of the questions below:
1. Why is the current cost system inadequate? Why is it necessary to report on customer profitability?
2. Develop a cost system for SCE based on Year 2012 data.
a. Identify major activities.
Subdivide these major categories into more detailed activities if necessary to improve
the accuracy of the cost system.
b. Calculate the cost-driver rate for each activity identified in 2a.
3. Combine your answers to question 2 with the information in Exhibit 4 to calculate the profitability of the average User, Subscriber, and Elite Team member. What explains the difference between the profitability of the different types of customers?
4. What actions should SCE management take based on the cost analysis?
Also, have a quick look at the Saharis.cz (B) case (immediately following the main case) and think about how the additional information could be used to better allocate the call center costs.
In 2010, Patrick Roman was transferred from corporate headquarters of Saharis.com in
Seattle, WA to spearhead expansion efforts in Central and Eastern Europe. He was appointed general manager of a newly created business unit, Saharis Central Europe (SCE), and charged with developing a newly created Saharis.cz domain and replicating the successful U.S. online retailing model, which was already taking foothold in several major European countries.
The business opportunities and challenges facing SCE were quite different from those
encountered in other countries. The heavy discounting strategy of Saharis appealed to price- conscious customers in the region. Another strategic advantage was access to low-cost labor and an efficient warehouse just outside Brno, Czech Republic.
The warehouse was the largest of its kind in Central Europe and was located within two-hour drive of four metropolitan areas with population of around 3 million, including the capitals of the Czech Republic and Slovakia. Given that no other online retailer established a major presence in the region, SCE competed against brick-and-mortar retail chains relying on stores in expensive downtown locations and charging higher prices.
Bigger malls outside of downtown areas were gaining in popularity but were less common than in the U.S. because of the relatively high cost of owning a car. However, much of the infrastructure Saharis relied on in other countries was underdeveloped. Slow postal service by Česká Pošta took 4 to 6 business days to deliver a package.
Premium services such as next day or second business day delivery, offered by DHL and FedEx, were expensive because the business volume in the region was still relatively low. SCE considered fast service critical to their success and set up their own delivery in selected areas.
Members of the “Elite Team” loyalty program who made sufficiently large orders qualified for second (business) day delivery. SCE charged a 5% shipping fee for this premium service or offered free shipping by postal service. Non-members paid the standard 5% shipping fee for the slower postal service.
SCE enticed customers into the Elite Team program by offering online perks such as
unlimited streaming of movies and music for a monthly fee of CZK 299 in the Czech Republic and €9 in Slovakia. A large majority of customers in the metropolitan areas had access to © 2014 by Michal Matějka. All rights reserved.
No part of this publication may be reproduced, electronically stored, or transmitted in any form by any means without permission. This case has been developed as a basis for class discussion. Although it has been inspired by real events, data presented here are not meant to accurately describe any specific industry or organization or represent the views of any real person.
sufficiently fast Internet connections to make these perks attractive. However, many
customers did not take full advantage of the perks and only streamed movies to their small- screen devices because smart TVs or set-top boxes enabling streaming from the Internet were only beginning to penetrate the market. Moreover, content distribution contracts in Europe were less favorable than in the U.S.
Although Elite Team customers enjoyed unlimited streaming, Saharis had to pay copyright fees based on the number of customers and their online content consumption. How much to charge for Elite Team membership was a point of continuous debate within SCE.
Patrick Roman was willing to subsidize Elite Team membership to get customers used to online transactions, to win their loyalty, and to increase capacity and utilization of internal delivery services. The membership program was critical in changing the local habit of ordering by phone and/or seeking the support of customer representatives to process payments, arrange for returns, etc.
This habit had roots in the past when mail order
catalogues relied on phone communication to win customer trust. SCE adjusted to customer expectations and set up a call center but the goal was to wean customers off this expensive service. A clause in the Elite Team membership contract limited the number of free phone transactions. Another initiative launched in 2011 was to sign up customers into “Subscriber” services.
Close cooperation and exclusive distribution contracts with consumer product companies such as Procter & Gamble and Unilever allowed SCE to offer a large number of everyday consumption items at 5–15% discounts relative to competition. Subscribers committed to a minimum order size and selected a day for regular monthly or quarterly deliveries.
Although Subscriber orders were typically larger and/or heavier than other orders, SCE only charged the standard 5% shipping and handling fee and used their internal delivery service to fulfill these orders. This service attracted a new type of clientele. Most Subscribers were not Elite
Team members but an increasing percentage of customers with a year or more of active Subscriber service signed up for the Elite Team program. Also, many Subscribes quickly grew accustomed to online transactions even if they chose not to become Elite Team members.
Patrick described the customer base and business growth opportunities as follows:
We have essentially three major types of customers—the Users, the Subscribers,
and the Elite Team. The Users demand call center support and, for now, we are
happy to provide it at the right price. We make money on some of the bigger
purchases such as electronics or jewelry.
We are willing to sacrifice profitability of many other items to get them accustomed to the great deals we offer and to the reliable service. The Subscribers are an unremarkable but steady source of revenues.
They also help us reach delivery volumes that make the second day service feasible. The Elite Team is where we see our future. Our vision is to offer free second or even next day delivery and make online shopping the default choice for most purchases of our customers.
Now, the big question is how to make it happen. We can sacrifice profitability in
the short term but we are already dealing with huge start‐up costs and we
cannot afford to lose too much money. We are lucky that Seattle does not push
us to break even quickly but, you know, their patience is going to run out at some
point…
Exhibit 1 provides more details on actual and forecasted growth in sales and customer
acquisitions (internal reporting and consolidation guidelines call for financial results to be reported in Euros). Patrick strongly felt that the strategy of emphasizing sales growth at the cost of short-term profits was justified.
At the same time, he knew that it is time to increase the focus on the bottom line. The current cost system was not much of a help because it allocated all overhead as a percentage of sales and thus made all sales look equally profitable. Patrick needed to better understand profitability of different types of customers. He hired a new business controller, Petr Mládek, to design a better cost system.
Overhead Cost Analysis
Petr could retrieve revenue and cost of goods sold per customer using income statement data (see Exhibit 2 and 3). The challenge was to how to assign overhead costs related to warehouse personnel, warehouse depreciation and equipment, shipping, call center support, marketing, technology, and administration. Petr collected additional information in the following areas.
Warehousing
The main warehouse processes were receiving, inspecting, storing, picking, packaging, and preparing customer orders for shipment. The warehouse featured robots, conveyor belts, and other automated equipment to deliver ordered items from shelves to packaging staff, although some items still had to be picked up manually.
A warehouse supervisor commented as follows:
Most of what we do is managing “loads.” Each manual pickup or each container
being transported automatically from the shelves to the packaging area is one
load. Multiple smaller items can fit into one load, e.g., multiple items of the same
SKU1 or different SKUs that are on nearby shelves. Most orders have multiple
loads as customer maximize order size to reduce shipping costs.
We can typically fit each order into one package for shipping but sometimes it is more than one package, especially if it is passed on to our second day delivery guys—they rather move two regular size packages than one big one. If you think in terms of costs, the more loads we have, the busier we are, and the more people I have to hire
and schedule. Over the last couple of years the number has been increasing
steadily.
The total number of items and loads processed in 2012 was 18 and 11 million, respectively.
The warehouse supervisor suggested that his staff was busy processing loads most of the time; the average downtime was only around 10% and could not be reduced much further.
Small increases in loads could be accommodated but sizeable increases meant additional 1 SKU or stock keeping unit is a unique code that identifies each distinct item available for purchase.
In contrast, only about 60% of the warehouse space and equipment capacity was utilized because SCE built in slack for future growth. The goal was to reach an industry standard of about 80% within a year or two.
Shipping
Packaged items were shipped either by standard postal service or by internal second day service in case of qualifying orders by Elite Team customers. In total, 5 million packages were shipped in 2012, of which 2 million went by postal service. SCE negotiated discounted postage rates that varied slightly depending on size and weight but were about the same for most packages. The remaining 3 million packages were shipped internally through 2.5 million deliveries.
Delivery vans operated by SCE were underutilized when travelling to
other than the most popular destinations. Managers estimated that they could accommodate 50% more deliveries with the same van fleet if they could increase the demand in some areas.
Call Center
Petr struggled to learn about call center operations. Ana Navrátilová, the department
manager was not very cooperative. She expressed her frustrations:
I do not think our work is appreciated very much. We are squeezed in the
smallest facility they could find and there are budget cuts every year.
I am sure
they would outsource us to India if only they could… It is very stressful to handle
calls all day long with almost no downtime. Employee turnover is very high…
In the end, Ana helped Petr collect 2012 data on call center processes. They identified three main activities.
The first one accounted for 30% of call center capacity and involved phone order set up including the recording of customer name, address, shipping and payment preferences, explaining of return policies, etc. In total, the call center processed 1.2 million phone orders.
The second activity accounted for 40% of call center capacity and involved processing of SKU choices, which included looking up item codes, verifying availability, explaining product features, refining choices (e.g. item size or color), recommending alternative products in case of stock-outs, etc.
The amount of work associated with this activity reflected the number of SKUs, i.e., no additional work was necessary when customers ordered multiple items of the same SKU. In total, 2.4 million SKUs were processed over the phone.
The third activity, general inquiries, accounted for the remaining 30% of the call center’s capacity. It resulted in no new orders and included for example advising of customers not yet ready to make a purchase or processing of returns. In total, there were about 500,000 such calls.
Other Expenses
Finally, Petr combed through expenses related to technology, marketing and selling, and general administration. He was not quite sure yet which expense subcategories would be relevant for his customer profitability analysis. Nevertheless, he identified the following 2012 expenses as potentially important: content licensing fees (€12 million); website development and maintenance (€3 million); IT support of internal operations (€1 million); marketing expenses related to promotion of Elite Team Membership (€3 million); administration, coordination, and support of internal delivery service (€2 million).
Now it was time to put it all together and report back to Patri ck Roman with
recommendations on how to increase customer profitability without losing track of sales growth targets.
Exhibit 1
Actual and Forecasted Growth
Exhibit 2
2012 Average Annual Gross Margin per Customer (in €)
2010 2011 2012 2013 2014 2015
Sales (in thousands) €110,000 €160,000 €250,000 €350,000 €450,000 €550,000
Number of customers
Elite Team 100,000 140,000 200,000 280,000 370,000 450,000
Subscribers 12,000 20,000 25,000 30,000 35,000
Users 140,000 150,000 157,000 170,000 180,000 190,000
Marketing of Elite Team
Program (in thousands) €5,000 €4,000 €3,000 €2,000 €1,000 €1,000
Actual Results Forecasts
Product Sales 400 500 800
Service Sales (Shipping & Handling) 20 25 20
Service Sales (Membership Programs) 0 0 108
Cost of Goods Sold 328 390 640
Gross Margin 92 135 288
User Subscriber Team Elite
WEEK 5 Activity-Based Costing Saharis Case
After a few weeks on the job Petr Mládek established a good working relationship with Ana Navrátilová, the call center manager. She helped him collect additional data on call center operations. First, he summarized the information obtained earlier.
The 2012 costs of call center operations was €5.4 million and the three main activities were as follows:
Percentage Volume
Phone order set up 30% 1.2 million orders
SKU processing 40% 2.4 million SKUs
General inquiries 30% 157,000 non-members
Second, he put together all additional information he could collect:
SCE employed 275 call center agents.
On average, it took 7 minutes to set up an order for a new customer, i.e., to collect
shipping address and payment information, to explain return policies, etc. Orders of
returning customers could take as little as 3 minutes to set up if they had their
payment information stored or 5 minutes if it had to be re-typed.
About 50% of phone orders came from new customers and 50% of orders were from returning customers. One out of five returning customers had agreed to have their payment information stored for future use.
It took 4 minutes on average to look up each SKU.
There were 500,000 general inquiries in 2012. The average inquiry took 14 minutes
to process. Petr planned to use this information to get an even better insight into the call center costs.
The idea was to set up a simple time-based activity-based costing system, which would also allow a better management of capacity utilization, an issue Ana Navrátilová kept complaining about.
