Question

Figure Four is a distributor of pharmaceutical products. Its ABC system has five​ activities:

Activity Area		Cost Driver Rate in 2013
1.	Order processing	$45 per order
2.	Line-item ordering	$7 per line item
3.	Store deliveries	$46 per store delivery
4.	Carton deliveries	$1 per carton
55.	Shelf-stocking	$20 per stocking-hour

Rick​ Flair, the controller of Figure Four​, wants to use this ABC system to examine individual customer profitability within each distribution market. He focuses first on the Ma and Pa​ single-store distribution market. Using only two customers helps highlight the insights available with the ABC approach. Data pertaining to these two customers in August 2013 are as​ follows:

		Dallas Pharmacy			Charleston Pharmacy
Total orders			15				12
Average line items per order			8				18
Total store deliveries			5				11
Average cartons shipped per store delivery			23				22
Average hours of shelf-stocking per store delivery			0.25				0.5
Average revenue per delivery			$2,250				$1,750
Average cost of goods sold per delivery			$2,150				$1,600
1.	Use the ABC information to compute the operating income of each customer in August 2013.Comment on the results and​ what, if​ anything, Flair should do.
2.	Flair ranks the individual customers in the Ma and Pa​ single-store distribution market on the basis of monthly operating income. The cumulative operating income of the top​ 20% of customers is $55,680. Figure Four reports operating losses of $18,290 for the bottom​ 40% of its customers. Make four recommendations that you think Figure Four should consider in light of this new​ customer-profitability information.

Answer 1

Part 1)

The value of operating income of each customer is calculated with the use of following table:

	Dallas Pharmacy	Charleston Pharmacy
Revenue	11,250 (5*2,250)	19,250 (11*1,750)
Less Cost of Goods Sold	10,750 (5*2,150)	17,600 (11*1,600)
Gross Profit (A)	500	1,650
Less Operating Costs
Order Processing	675 (15*45)	540 (12*45)
Line-Item Ordering	840 (15*8*7)	1,512 (12*18*7)
Store Deliveries	230 (5*46)	506 (11*46)
Carton Deliveries	115 (5*23*1)	242 (11*22*1)
Shelf-Stocking	25 (5*.25*20)	110 (11*.50*20)
Total Operating Costs (B)	1,885	2,910
Net Operating Income (A-B)	-$1,385	-$1,260

Based on the above calculations, we can see that Charleston Pharmacy generates a higher gross margin of 8.57% (1,650/19,250*100) than the 4.44% (500/11,250*100) generated by Dallas Pharmacy and even after using more resources, Charleston Pharmacy results in lower negative net operating income. This indicates that Flair should focus more on Charleston Pharmacy.

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Part 2)

The four recommendations are provided as below:

1) Pay incentives to sales representatives/agents based on the profitability of the customers.

2) Focus on reducing customers (from bottom 40%) contributing to operating losses. That is, try to reduce sales to customers who are resulting in losses for the company.

3) Additional discounts/schemes may be provided to top 20% customers to generate additional business from them. This would reduce the need to depend on bottom 40% customers for more sales and also the risk of negative results.

4) Identify and eliminate non-value adding activities that are causing an increase in the overall costs.