Customer Profitability and Relevant Costs

Learning Objective 6 Discuss the factors managers must consider when adding or dropping customers or business units

managers should focus on how total revenues and costs differ among alternatives and ignore allocated overhead costs

Managers must often make decisions about adding or dropping a product line or a business segment. Similarly, if the cost object is a customer, managers must decide about adding or dropping customers (analogous to a product line) or a branch office (analogous to a business segment or division). We illustrate relevant-revenue and relevant-cost analysis for these decisions using customers rather than products as the cost object.

Example 5

Allied West, the West Coast sales office of Allied Furniture, a wholesaler of specialized furniture, supplies furniture to three local retailers: Vogel, Brenner, and Wisk. Exhibit 12-8 presents expected revenues and costs of Allied West by customer for the upcoming year using its activity-based costing system. Allied West’s management accountant assigns costs to customers based on the activities needed to support each customer. Information on Allied West’s costs for different activities at various levels of the cost hierarchy are as follows:

Furniture-handling labor costs vary with the number of units of furniture shipped to customers.
Allied West reserves different areas of the warehouse for different customers. For simplicity, we assume that furniture-handling equipment in an area and depreciation costs on the equipment that Allied West has already acquired are identified with individual customers (customer-level costs). Any unused equipment remains idle. The equipment has a 1-year useful life and zero disposal value.
Allied West allocates its fixed rent costs to each customer on the basis of the amount of warehouse space reserved for that customer.
Marketing support costs vary with the number of sales visits made to customers.
Sales-order costs are batch-level costs that vary with the number of sales orders received from customers. Delivery-processing costs are batch-level costs that vary with the number of shipments made.
Allied West allocates fixed general-administration costs (facility-level costs) to customers on the basis of customer revenues.
Allied Furniture allocates its fixed corporate-office costs to sales offices on the basis of the budgeted costs of each sales office. Allied West then allocates these costs to customers on the basis of customer revenues.

Exhibit 12-8

Customer Profitability Analysis for Allied West

1. The revenue and cost details of customer Vogel are as follows:

• Revenues: $500,000

• Cost of goods sold: $370,000

• Furniture-handling labor: $41,000

• Furniture-handling equipment cost written off as depreciation: $12,000

• Rent: $14,000

• Marketing support: $11,000

• Sales order and delivery processing: $13,000

• General administration: $20,000

• Allocated corporate-office costs: $10,000

• Total costs: $491,000

• Operating income: $9,000

2. The revenue and cost details of customer Brenner are as follows:

• Revenues: $300,000

• Cost of goods sold: $220,000

• Furniture-handling labor: $18,000

• Furniture-handling equipment cost written off as depreciation: $4,000

• Rent: $8,000

• Marketing support: $9,000

• Sales order and delivery processing: $7,000

• General administration: $12,000

• Allocated corporate-office costs: $6,000

• Total costs: $284,000

• Operating income: $16,000

3. The revenue and cost details of customer Wisk are as follows:

• Revenues: $400,000

• Cost of goods sold: $330,000

• Furniture-handling labor: $33,000

• Furniture-handling equipment cost written off as depreciation: $9,000

• Rent: $14,000

• Marketing support: $10,000

• Sales order and delivery processing: $12,000

• General administration: $16,000

• Allocated corporate-office costs: $8,000

• Total costs: $432,000

• Operating income: $32,000 within parentheses

4. Total

• Revenues: $1,200,000

• Cost of goods sold: $920,000

• Furniture-handling labor: $92,000

• Furniture-handling equipment cost written off as depreciation: $25,000

• Rent: $36,000

• Marketing support: $30,000

• Sales order and delivery processing: $32,000

• General administration: $48,000

• Allocated corporate-office costs: $24,000

• Total costs: $1,207,000

• Operating income: $7,000 within parentheses

In the following sections, we consider several decisions that Allied West’s managers face: Should Allied West drop the Wisk account? Should it add a fourth customer, Loral? Should Allied Furniture close down Allied West? Should it open another sales office, Allied South, whose revenues and costs are identical to those of Allied West?

Relevant-Revenue and Relevant-Cost Analysis of Dropping a Customer

Exhibit 12-8 indicates a loss of $32,000 on the Wisk account because Wisk places low-margin orders with Allied and has relatively high sales-order, delivery-processing, furniture-handling, and marketing costs. Allied West’s managers are considering several possible actions for the Wisk account: reducing the costs of supporting Wisk by becoming more efficient; cutting back on some of the services Allied West offers Wisk; asking Wisk to place larger, less frequent orders; charging Wisk higher prices; or dropping the Wisk account. The following analysis focuses on the annual operating-income effect of dropping the Wisk account.

Allied West’s managers and management accountants first focus on relevant revenues and relevant costs. Dropping the Wisk account will

Save cost of goods sold, furniture-handling labor, marketing support, sales-order and delivery-processing costs incurred on the account;
Leave idle the warehouse space and furniture-handling equipment currently used to supply products to Wisk;
Not affect the fixed rent costs, general administration costs, or corporate-office costs.

Exhibit 12-9, column 1, presents the relevant-revenue and relevant-cost analysis using data from the Wisk column in Exhibit 12-8. The $385,000 cost savings from dropping the Wisk account will not be enough to offset the $400,000 loss in revenues. Because Allied West’s operating income will be $15,000 lower if it drops the Wisk account, Allied West’s managers decide to keep the Wisk account. They will, of course, continue to find ways to become more efficient, change Wisk’s ordering patterns, or charge higher prices.

Table shows the relevant-revenue and relevant-cost analysis for dropping the account of customer Wisk and adding customer Loral’s account.

The details of the table are as follows:

A. Incremental loss in revenues and incremental savings in costs from dropping the account of Wisk

• Revenues: $400,000 within parentheses

• Cost of goods sold: $330,000

• Furniture-handling labor: $33,000

• Furniture-handling equipment cost written off as depreciation: $0

• Rent: $0

• Marketing support: $10,000

• Sales order and delivery processing: $12,000

• General administration: $0

• Corporate-office costs: $0

• Total costs: $385,000

• Effect on operating income which is a loss of $15,000 within parentheses

B. Incremental revenues and incremental costs from adding the account of Loral

• Revenues: $400,000

• Cost of goods sold: $330,000 within parentheses

• Furniture-handling labor: $33,000 within parentheses

• Furniture-handling equipment cost written off as depreciation: $9,000 within parentheses

• Rent: $0

• Marketing support: $10,000 within parentheses

• Sales order and delivery processing: $12,000 within parentheses

• General administration: $0

• Corporate-office costs: $0

• Total costs: $394,000 within parentheses

• Effect on operating income which is a loss of $6,000

Depreciation on equipment that Allied West has already acquired is a past cost and therefore irrelevant. Rent, general administration, and corporate-office costs are future costs that will not change if Allied West drops the Wisk account and are also irrelevant.

Corporate-office costs allocated to the sales office and individual customers are always irrelevant. The only question is, will expected total corporate office costs decrease as a result of dropping the Wisk account? In our example, they will not, so these costs are irrelevant. If expected total corporate-office costs were to decrease by dropping the Wisk account, those savings would be relevant even if the amount allocated to Wisk did not change.

Note that there is no opportunity cost of using warehouse space and equipment for Wisk because there is no alternative use for them. That is, the space and equipment will remain idle if managers drop the Wisk account. But suppose Allied West could lease the available extra space and equipment to Sanchez Corporation for $20,000 per year. Then $20,000 would be Allied West’s opportunity cost of continuing to use the warehouse to service Wisk. Allied West would gain $5,000 by dropping the Wisk account ($20,000 from lease revenue minus lost operating income of $15,000). Under the total alternatives approach, the revenue loss from dropping the Wisk account would be $inline style straight $ text 380,000 end text straight thin space left parenthesis straight $ text 400,000 end text minus straight $ text 20,000 end text right parenthesis$ versus the savings in costs of $385,000 (Exhibit 12-9, column 1). Before reaching a decision, Allied West’s managers must examine whether Wisk can be made more profitable so that supplying products to Wisk earns more than the $20,000 from leasing to Sanchez. The managers must also consider strategic factors such as the effect of dropping the Wisk account on Allied West’s reputation for developing stable, long-run business relationships with its customers.