Question

Advertising Technologies, Inc. (ATI) specializes in providing both published and online advertising services for the business marketplace. The company monitors its costs based on the cost per column inch of published space printed in print advertising media and based on the cost per minute of telephone advertising time delivered on “The AD Line, a computer-based, online advertising service. ATI has one new competitor, Tel-a-Ad, in its local teleadvertising market; and with increased competition, ATI has seen a decline in sales of online advertising in recent years. ATI’s president, Robert Beard, believes that predatory pricing by Tel-a-Ad has caused the problem. The following is a recent conversation between Robert and Jane Minnear, director of marketing for ATI.

Jane:    I just received a call from one of our major customers concerning our advertising rates on “The AD Line” who said that a sales rep from another firm (it had to be Tel-a-Ad) had offered the same service at $1 per minute, which is $1.50 per minute less than our price.

Robert: It’s costing about $1.27 per minute to produce that product. I don’t see how they can afford to sell it so cheaply. I’m not convinced that we should meet the price. Perhaps the better strategy is to emphasize producing and selling more published ads, which we’re more experienced with and where our margins are high and we have virtually no competition.

Jane: You may be right. Based on a recent survey of our customers, I think we can raise the price significantly for published advertising and still not lose business.

Robert: That sounds promising; however, before we make a major recommitment to publishing, let’s explore other possible explanations. I want to know how our cots compare with our competitors. Maybe we could be more efficient and find a way to earn a good return on tele advertising.

After this meeting, Robert and Jane requested an investigation of production costs and comparative efficiency of producing published versus online advertising services. The controller, Tim Gentry, indicated that ATI’s efficiency was comparable to that of its competitors and prepared the following cost data:

	Published Advertising	Online Advertising
Estimated number of production units	200,000	10,000000
Selling Price	$200	$2.50
Direct Product Costs	$21,000,000	$5,000,000
Overhead Allocation (based on DL costs)	$10,175,000	$8,325,000
Overhead per unit	$49	$0.77
Direct costs per unit	$105	$0.50
# of customers	180,000	25,000
# of salesperson days	28,500	3,500
# of art and design hours	35,000	5,000
# of creative services subcontract hours	100,000	25,000
# of customer service calls	72,000	8,000

Upon examining the data, Robert decided that he wanted to know more about the overhead costs since they were such a high proportion of total production costs. He was provided the following list of overhead costs and told that they were currently being assigned to products in proportion to direct labor costs.

Selling costs	$8,000,000
Visual and audio design costs	$3,000,000
Creative services costs	$5,500,000
Customer service costs	$2,000,000
Total Overhead costs	$18,500,000

Required:

Using the data provided by the controller, prepare analyses to help Robert and Jane in making their decisions. Prepare an executive memo which touches on the following points: Should ATI switch from the fast-growing, online advertising market back into the well-established published advertising market? Does the charge of predatory pricing seem valid? Why are customers likely to be willing to pay a higher price to get published services?

Answer 1

Observations;

- Existing allocation of overheads cost is based on proportion of direct labour cost. Based on this assumption actual cost per unit is $155.88 per unit (column inch of published space) for published advertising and $1.33 per unit (minute of telephone adverstising time delivered) for online advertising

- Under ABC method, actual cost per unit is $184.75 for published advertising and $0.76 for online advertising.

- There is significant difference in cost per unit under two different methods. Existing method allocates overheads on direct labour cost which may not correctly reflect overheads costs as overheads will not depend entirely on labour costs. This very general approach and may mislead.

Whereas ABC method works on principal of assigning different overheads cost to different cost drivers. [refer basis column in ABC cost sheet] It stresses on using such parameters as basis which are directly related to the activity. Like Creative service cost is allocated based on creative service subcontract hours which are directly related and represent a realistic basis for allocation.

- Company is trying to understand how the competitor is able to deliver online advertising services at very low price of $1 per unit whereas their cost estimate is of $1.27 per unit (actual $1.33 per unit) However ABC method shows that per unit cost of online advertising is $0.76. This means that they were charging super normal profit on online advertising ($2.5 - $0.76) which the competitor wasn't. Competitor was charging substantially lower price and was still making sufficient profits

- Also ABC analysis shows that actual cost of published advertising is $184.75 against $155.88 under existing costing system. It means that margin available under this product is not that big. If company considers proposal of shifting focus on published advertising it will not be able to garner enough profit to compensate for online advertising.

- To summerise, the company should evaluate what price it can charge for its online advertising based on data under ABC method. It should also evaluate any opportunity to increase selling price of published advertising business if market conditions are favourable. This will result in maximization of profits