Customer-Level Costs

Exhibit 15-2 summarizes details of the costs incurred in marketing and administration, distribution, and customer service by activity. The exhibit also identifies the cost driver (where appropriate), the total costs incurred for the activity, the total quantity of the cost driver, the cost per unit of the cost driver, and the customer cost-hierarchy category for each activity.

For example, here is a breakdown of Provalue Division’s $15,000,000 of marketing and administration costs:

• $6,750,000 of sales-order costs, which include negotiating, finalizing, issuing, and collecting on 6,000 sales orders at a cost of $\$\text{1,125} (\mathrm{\$}\text{6,750,000}÷\text{6,000})$ per sales order. Recall that sales-order costs are customer batch-level costs because these costs vary with the number of sales orders issued and not with the number of Provalue computers in a sales order.
• $4,200,000 for customer visits, which are customer-sustaining costs. The amount per customer varies with the number of visits to that customer rather than the number of units or batches of Provalue delivered to that customer.
• $800,000 on managing the wholesale channel, which are distribution-channel costs.
• $1,350,000 on managing the business-sales channel, which are distribution-channel costs.
• $1,900,000 on general administration of the Provalue Division, which are division-sustaining costs.

The Provalue Division managers are particularly interested in analyzing customer-level ­indirect costs—costs incurred in the first three categories of the customer-cost hierarchy: customer output unit–level costs, customer batch-level costs, and customer-sustaining costs. Managers believe they can work with customers to influence customer actions to reduce these costs. Information on the quantity of cost drivers used by each of four representative wholesale customers follows:

Exhibit 15-3 shows customer-level operating income for the four wholesale customers using information on customer revenues previously presented (see section Customer-Revenue Analysis) and customer-level indirect costs, obtained by multiplying the rate per unit of cost driver (from Exhibit 15-2) by the quantities of the cost driver used by each customer (in the preceding table). Exhibit 15-3 shows that the Provalue Division makes losses on Customer G (the cost of resources used exceeds revenues) while Customer J is profitable on smaller revenues. In a similar vein, the Provalue Division has higher operating income from Customer B than Customer A even though it sells fewer computers to Customer B compared to Customer A.

The Provalue Division’s managers can use the information in Exhibit 15-3 to work with customers to reduce the quantity of activities needed to support them. Consider, for example, Customer G and Customer J. Customer G purchases 25% more computers than Customer J (5,000 versus 4,000) but the company offers Customer G significant price discounts to achieve these sales. Compared with Customer J, Customer G places twice as many sales orders, requires twice as many customer visits, and generates two-and-a-half times as many regular shipments and almost seven times as many rush shipments. Selling smaller quantities of Provalue is profitable so long as price discounting is limited and customers do not use large amounts of division resources. For example, charging customers for marketing (sales orders and customer visits) and distribution services (regular and rush shipments) might motivate Customer G to place fewer but larger sales orders and require fewer customer visits, regular shipments, and rush shipments. A similar analysis might help managers understand the reasons for the lower profitability of Customer A relative to Customer B and actions they might take to improve Customer A’s profitability.

Owens and Minor, a distributor of medical supplies to hospitals, separately prices each of its services such as a rush delivery or special packaging. How have its customers reacted? Hospitals that value these services continue to demand and pay for them, while hospitals that do not value these services stop asking for them, saving Owens and Minor some costs. This pricing strategy influences customer behavior in a way that increases Owens and Minor’s revenues or decreases its costs.

The ABC system also highlights a second opportunity for cost reduction. Provalue Division managers can reduce the costs of activities by applying a value-engineering process to nonmanufacturing costs: (1) understand customer requirements and value-added and non-value-added costs, (2) anticipate how costs are locked in before they are incurred, and (3) use cross-functional teams to redesign products and processes to reduce costs while meeting customer needs. For example, improving the efficiency of the ordering process (through electronic ordering) reduces sales-order costs even if customers place the same number of orders.

Simplifying the design and reducing the weight of the newly designed Provalue II for 2020 reduces the cost per cubic foot of handling Provalue and total product-handling costs. By influencing customer behavior and improving marketing, distribution, and customer-service operations, managers aim to reduce the nonmanufacturing cost of Provalue II to $180 per computer and achieve the target cost of $720 for Provalue II.