Midwest office Products

...

Based on the cost calculations above, the cost and profitability of five representative orders chosen for study by MOP management are shown below.[pic 1]

As you can see, the activity based costing analysis shown above for the five orders reveals differences in costs that were not apparent in the aggregated data from the income statement. A few specific items immediately stand out:

- Freight/delivery costs range from a low of 1.2% for commercial shipments to a high of 60% of the total acquisition cost for a 4-hour delivery of a single carton to a customer! In that instance, MOP charged a premium delivery fee of $24 to the customer when it actually cost them $300 to make the delivery via their desktop delivery system, resulting in a loss of $253 on the order.

- Operator Entry Costs vary from .07% for an electronic order with 10 line items to 1.58% for a manual order with only 1 line item, while the income statement showed an average of 2.4% across all orders.

- Based on the length of time each customer took to pay for the order, the 1% interest charge MOP has to pay on its working capital loan can be quite significant – up to a maximum of $253.60 or 5% of the acquisition cost of the order.

CONCLUSION

Given the above analysis of the cost drivers for Midwest Office Products, there are several changes that Mr. Malone should consider to improve MOP’s profitability. By viewing the cost data in a consolidated form as MOP had been doing previously, it was difficult to determine the company’s real drivers of cost; however, once we break down the order data, the cost drivers and opportunities for correction become apparent. Our recommended changes are outlined below:

- MOP needs control its Accounts Receivable balances by making a change in the company’s payment terms to include an interest penalty or late fee for any customer accounts outstanding longer than 30 days. In operational terms, this is the simplest change to make but it has a significant cost savings implication since MOP paid $120,000 in interest expenses on its working capital loan last year. This change wouldn’t eliminate interest expense entirely, but it should make a significant reduction in this line item.

- Mr. Malone should reevaluate the benefits of his desktop delivery system, as it is a huge driver of costs. MOP is charging a premium of about 5% of the selling price for this option, but with drivers making deliveries that can take up to 8 hours, this delivery method is not practical at least for orders below a certain minimum amount. MOP must either increase the premium charged for this delivery option, set a minimum order amount to qualify for desktop delivery, limit the delivery radius or a combination of these options if it wants to continue offering this service to its customers. Commercial delivery or even drop shipments of certain items directly from the manufacturer could be much more cost effective options for delivering products. To help in determining which of these changes to make, MOP could survey its customer base to gain an understanding of what value they place on this premium delivery service and what additional amount they would be willing to pay for it.

- Customers should be encouraged to use electronic ordering as often as possible. The cost of entering manual orders is a significant drain, especially on smaller orders. MOP could offer an incentive to customers for using the online ordering option or could even make it the only ordering method available for orders under a certain dollar amount. Also, reducing the number of manual orders could also allow the company to reduce the number of operators needed for order entry, thereby reducing expenses further.

Finally, there are a couple other items that Mr. Malone could consider, but for which we don’t have enough data in the case study to make a determination.

- Would a just-in-time inventory system be a viable option? If we knew how much inventory is typically on-hand in the warehouse and how long it’s held, we could calculate inventory carrying costs. It may be that a JIT ordering system would allow the company to save money on overhead by having a smaller warehouse, which would also reduce handling and processing costs since fewer workers, forklifts, shelves, etc. would be needed and staff would spend less time picking orders if the space were more compact.

- The order entry department seems to be expensive and inefficient. The case indicates that with vacation and holidays, each operator works about 1,750 hours per year. With 2080 available working hours in a year, our calculations show that on average each operator has 8.25 weeks of vacation and holidays per year. Unless this is a European company, this number seems out of line with a typical vacation and holiday package.

Without knowing more detail about these two items, we can’t recommend a solution; they just stood out as issues we would investigate further.

Midwest Office Products had concerns about a net loss in the previous year, the potential causes of which were being masked by the aggregated way in which they were reporting cost data. The culprits driving the loss were easily identified by simply breaking down the cost data by order type, delivery method and payment days, thereby identifying numerous opportunities for operational changes that will result in cost savings and increased profitability for the company. Mr. Malone’s concern about the net loss in the previous year drove him to properly investigate his costs, and that provided him with the answers he needed to make appropriate corrections going forward.