Customer profitability, distribution

Best Drugs is a distributor of pharmaceutical products. Its ABC system has five activities:

Rick Flair, the controller of Best Drugs, wants to use this ABC system to examine individual customer profitability within each distribution market. He focuses first on the Ma and Pa single-store distribution market. Using only two customers helps highlight the insights available with the ABC approach. Data pertaining to these two customers in August 2013 are as follows:

Required:
1. Use the ABC information to compute the operating income of each customer in August 2013. Comment on the results and what, if anything, Flair should do.
2. Flair ranks the individual customers in the Ma and Pa single-store distribution market on the basis of monthly operating income. The cumulative operating income of the top 20% of customers is $58,120. Best Drugs reports operating losses of $23,670 for the bottom 40% of its customers. Make four recommendations that you think Best Drugs should consider in light of this new customer-profitability information.

1. The activity-based costing for each customer is:

Ann Arbor
Pharmacy San Diego
Pharmacy
1. Order processing,
$42 × 13; $42 × 7 $ 546.00 $ 294.00
2. Line-item ordering,
$5 × (13 × 11; 7 × 19) 715.00 665.00
3. Store deliveries,
$47 × 5; $47 × 7 235.00 329.00
4. Carton deliveries,
$4 × (5 × 21; 7 × 18) 420.00 504.00
5. Shelf-stocking,
$13 × (5 × 0.5; 7 × 0.75) 32.50 68.25
Operating costs $1,948.50 $1,860.25

The operating income of each customer is:
Ann Arbor
Pharmacy San Diego
Pharmacy
Revenues,
$2,600 × 5; $1,900 × 7 $13,000.00 $13,300.00
Cost of goods sold,
$2,100 × 5; $1,700 × 7 10,500.00 11,900.00
Gross margin 2,500.00 1,400.00
Operating costs 1,948.50 1,860.25
Operating income $ 551.50 $ (460.25)

San Diego Pharmacy has a lower gross margin percentage than does Ann Arbor [10.5% ($1,400 ÷ $13,300) vs. 19.2% ($2,500 ÷ $13,000)] and consumes more resources to obtain this lower margin. Serving San Diego necessitates more deliveries and delivery of more line items in each order, albeit lower-priced ones that don't contribute much to Best Drugs' income. Overall, Ann Arbor is a profitable customer, while San Diego is not.

2. Ways Best Drugs could use this information include:
a. Pay increased attention to the top 20% of the customers. This could entail asking them for ways to improve service. Alternatively, Best Drugs may want to highlight to their own personnel the importance of these customers; e.g., it could entail stressing to delivery people the importance of never missing delivery dates for these customers.
b. Work out ways internally at Best Drugs to reduce the rate per cost driver; e.g., reduce the cost per order by having better order placement linkages with customers. This cost reduction by Best Drugs will improve the profitability of all customers.
c. Work with customers so that their behavior reduces the total "system-wide" costs. At a minimum, this approach could entail having customers make fewer orders and fewer line items. This latter point is controversial with students; the rationale is that a reduction in the number of line items (diversity of products) carried by Ma and Pa stores may reduce the diversity of products Best Drugs carries.

There are several options here:
• Simple verbal persuasion by showing customers cost drivers at Best Drugs.
• Explicitly pricing out activities like cartons delivered and shelf-stocking so that customers pay for the costs they cause.
• Restricting options available to certain customers, e.g., customers with low revenues could be restricted to one free delivery per week.

An even more extreme example is working with customers so that deliveries are easier to make and shelf-stocking can be done faster.

d. Offer salespeople bonuses based on the operating income of each customer rather than the gross margin of each customer.

Some students will argue that the bottom 40% of the customers should be dropped. This action should be only a last resort after all other avenues have been explored. Moreover, an unprofitable customer today may well be a profitable customer tomorrow, and it is myopic to focus on only a one-month customer-profitability analysis to classify a customer as unprofitable.