Activity-based costing, merchandising

Pharmahelp, Inc., a distributor of special pharmaceutical products, operates at capacity and has three main market segments:

a. General supermarket chains
b. Drugstore chains
c. Mom-and-pop single-store pharmacies

Rick Flair, the new controller of Pharmahelp, reported the following data for 2014

For many years, Pharmahelp has used gross margin percentage [(Revenue – Cost of goods sold) ÷ Revenue] to evaluate the relative profitability of its market segments. But Flair recently attended a seminar on activity- based costing and is considering using it at Pharmahelp to analyze and allocate "other operating costs." He meets with all the key managers and several of his operations and sales staff, and they agree that there are five key activities that drive other operating costs at Pharmahelp:

Each customer order consists of one or more line items. A line item represents a single product (such as Extra-Strength Tylenol Tablets). Each product line item is delivered in one or more separate cartons. Each store delivery entails the delivery of one or more cartons of products to a customer. Pharmahelp's staff stacks cartons directly onto display shelves in customers' stores. Currently, there is no additional charge to the customer for shelf-stocking and not all customers use Pharmahelp for this activity. The level of each activity in the three market segments and the total cost incurred for each activity in 2014 is as follows:

Required:
1. Compute the 2014 gross-margin percentage for each of Pharmahelp's three market segments.
2. Compute the cost driver rates for each of the five activity areas.
3. Use the activity-based costing information to allocate the $301,080 of "other operating costs" to each of the market segments. Compute the operating income for each market segment.
4. Comment on the results. What new insights are available with the activity-based costing information?

1. General
Supermarket
Chains
Drugstore
Chains Mom-and-Pop
Single
Stores

Total
Revenues $3,708,000 $3,150,000 $1,980,000 $8,838,000
Cost of goods sold 3,600,000 3,000,000 1,800,000 8,400,000
Gross margin $ 108,000 $ 150,000 $ 180,000 $ 438,000
Other operating costs 301,080
Operating income $ 136,920

Gross margin % 2.91% 4.76% 9.09%
The gross margin of Pharmahelp, Inc., was 4.96% ($438,000 ÷ $8,838,000). The operating income margin of Pharmahelp, Inc., was 1.55% ($136,920 ÷ $8,838,000).

2. The per-unit cost driver rates are:

1. Customer purchase order processing,
$80,000 ÷ 2,000 (140 + 360 + 1,500) orders = $40 per order
2. Line item ordering,
$63,840 ÷ 21,280 (1,960 + 4,320 + 15,000) line items = $ 3 per line item
3. Store delivery,
$71,000 ÷ 1,480 (120 + 360 + 1,000) deliveries = $47.973 per delivery
4. Cartons shipped,
$76,000 ÷ 76,000 (36,000 + 24,000 + 16,000) cartons = $ 1 per carton
5. Shelf-stocking,
$10,240 ÷ 640 (360 + 180 + 100) hours = $16 per hour

3. The activity-based costing of each distribution market for 2014 is:

General
Supermarket
Chains Drugstore Chains Mom-and-Pop
Single Stores Total
1. Customer purchase order processing
($40 ? 140; 360; 1,500) $ 5,600 $14,400 $ 60,000 $ 80,000
2. Line item ordering
($3 ? 1,960; 4,320; 15,000) 5,880 12,960 45,000 63 ,840
3. Store delivery
($47.973 ? 120; 360; 1,000) 5,757 17,270 47,973 71,000
4. Cartons shipped
($1 ? 36,000; 24,000; 16,000) 36,000 24,000 16,000 76,000
5. Shelf-stocking
($16 ? 360; 180; 100) 5,760 2,880 1,600 10,240
$58,997 $71,510 $170,573 $301,080

The revised operating income statement is:
General Mom-and-Pop
Supermarket Drugstore Single
Chains Chains Stores Total
Revenues $3,708,000 $3,150,000 $1,980,000 $8,838,000
Cost of goods sold 3,600,000 3,000,000 1,800,000 8,400,000
Gross margin 108,000 150,000 180,000 438,000
Operating costs 58,997 71,510 170,573 301,080
Operating income $ 49,003 $ 78,490 $ 9,427 $ 136,920

Operating income margin 1.32% 2.49% 0.48% 1.55%

4. The ranking of the three markets are:

Using Gross Margin Using Operating Income

1. Mom-and-Pop Single Stores 9.09% 1. Drugstore Chains 2.49%
2. Drugstore Chains 4.76% 2. General Supermarket Chains 1.32%
3. General Supermarket Chains 2.91% 3. Mom-and-Pop Single Stores 0.48%

The activity-based analysis of costs highlights how the Mom-and-Pop Single Stores use a larger amount of Pharmahelp's resources per revenue dollar than do the other two markets. The ratio of the operating costs to revenues across the three markets is:

General Supermarket Chains 1.59% ($58,997 ÷ $3,708,000)
Drugstore Chains 2.27% ($71,510 ÷ $3,150,000)
Mom-and-Pop Single Stores 8.61% ($170,573 ÷ $1,980,000)

This is a classic illustration of the maxim that "all revenue dollars are not created equal." The analysis indicates that the Mom-and-Pop Single Stores are the least profitable market. Pharmahelp should work to increase profits in this market through (1) a possible surcharge, (2) decreasing the number of orders, (3) offering discounts for quantity purchases, etc.

Other issues for Pharmahelp to consider include:
a. Choosing the appropriate cost drivers for each area. The problem gives a cost driver for each chosen activity area. However, it is likely that over time further refinements in cost drivers would be necessary. For example, not all store deliveries are equally easy to make, depending on parking availability, accessibility of the storage/shelf space to the delivery point, etc. Similarly, not all cartons are equally easy to deliver––their weight, size, or likely breakage component are factors that can vary across carton types.

b. Developing a reliable data base on the chosen cost drivers. For some items, such as the number of orders and the number of line items, this information likely would be available in machine readable form at a high level of accuracy. Unless the delivery personnel have handheld computers that they use in a systematic way, estimates of shelf-stocking time are likely to be unreliable. Advances in information technology likely will reduce problems in this area over time.
c. Deciding how to handle costs that may be common across several activities. For example, (3) store delivery and (4) cartons shipped to stores have the common cost of the same tri