As president and primary owner of Almarai, Inc., Hamdan was beginning to realize that retaining longterm customers was becoming a challenge. During a delivery run yesterday, driver Saeed had noticed a competitor’s sales manager talking with the general manager of LuLu Hypermarket, one of Almarai largest customers. Then, that morning, Hamdan’s sales manager, Bassam, had mentioned that during her visit with the same general manager on Wednesday, he was starting to make some noises about wanting to negotiate a lower price. This could cause a dilemma because this customer had been one of the company’s largest and most loyal customers for years.
Hamdan leaned back in his chair. These things always seemed to come up on Thursday—just in time to monopolize his thoughts over what otherwise would have been a restful weekend. Deciding to address the situation head-on, he scheduled a meeting with Saeed, Bassam and several others for later that afternoon.
Company Background:
Almarai distributed Milk to retail customers. The company had been in business for two decades and had become a preferred distributor among several retail outlets in the local area. Almarai is primarily distributed to bottled milk and its business had grown steadily over the past 10 to 20 years. Last year, Almarai revenues totalled $18 million. The company serviced about 20 customers whose Milk purchases totalled anywhere from about $150,000 to over $1.5 million annually. The undiscounted list price on the spoils drinks that Milk distributed was $15.20 per case of 6 bottles. The full cost (excluding customer services costs) of the bottled drinks was $13.10 per case. The company offered discounts to some of its customers, which varied by customer based on a number of factors, including the volume of milk the customer purchased, the future potential of the customer, and the negotiating success of the company’s sales representative, among others.
The meeting:
Hamdan opened the meeting by summarizing what he had heard from Saeed and Bassam over the past couple of days. “It looks like we’ve got some competition for one of our best customers: LuLu. I guess I am not too surprised. They’re a big customer.” “This isn’t the first time this has happened,” added Bassam. “You might remember that this same competitor has approached LuLu before. But that time, we were able to keep the business by offering a bit more of a discount. I think we’ll have to do more of that this time, or I’m afraid we’ll lose the customer.”
Hamdan responded quickly. “We can’t get into a price war on this. I know this is a big customer, and a loyal one too, but LuLu is certainly not one of our most profitable. I had pull some numbers together on several of our accounts. LuLu is one of our lowest-margin customers. Take a look.” Tamara in accounting, who was also in the meeting, had prepared a report (Exhibit 1), which Hamdan laid on the table for the others to look at.
Exhibit:
Report of customer profitability during the previous year for four customers prepared by
Tamara
LuLu Carrefour Almira
Convenient
stores
Total
Net revenue $ 1,752,000 $ 1,788,000 $ 182,280 $ 681,750 $ 18,000,000
Cost of goods sold (1,572,000) (1,572,000) (157,200) (589,500) (15,720,000)
Gross margin 180,000 216,000 25,080 92,250 2,280,000
Customer services cost (175,200) (178,800) (18,228) (68,175) (1,800,000)
Customer profit $ 4,800 $ 37,200 $ 6,852 $ 24,075 $ 480,000
Customer profit (% of net revenue) % 0.3 % 2.1 % 3.76 % 3.53 % 2.7
Tamara explained how the accounting group compiled the numbers:
For each customer, we just pull the revenues right out of the accounting system. We know what they ordered and what we shipped, and we know what price we charge each customer, so that part is pretty easy. And we know that the cost per ease, excluding our customer service costs, is $13.10. So we can multiply $13.10 per ease by the number of cases we shipped to get our cost of goods. Then, subtract our cost of goods from revenues for each customer and get a gross margin. Now, you may remember that we’ve talked about how hard it is to trace our customer service costs to any particular customer. Our customer service costs run about $1.8 million a year, roughly 10% of revenues. To make things easy, we allocate those to each customer based on its share of the company’s total revenues. So if a customer accounts for 5% of our revenues, we allocate it 5% of cur customer service costs.
Then, we calculate a customer margin for each customer.
Hamdan looked at the numbers and said:
I don’t think we can lower our price to LuLu much more and make any money on this one. And just think, if we offer a larger discount to them, then is we’ll have our other customers wanting the same thing—especially the other big ones. I can see it now: Marsha is going to walk in here next month and tell us that Carrefour has heard about the deal we struck with LuLu, has been talking with that competitor, and they want the same thing.
Carrefour, a large local retailer on the edge of town, was another of Almarai’s large customers.
Tarek, the operations manager for ml, was listening carefully. This was the first he had heard of the situation, but to a careful observer, his nod would have revealed what he was thinking. He said: You know, I’m not a bit surprised to hear all this. LuLu is a great customer. They buy lots of Milks, and they’re easy to deal with. They place their orders on a regular basis and almost never ask for anything special. I don’t remember the last time we had to run around in the warehouse pulling together a rush order from them. Who wouldn’t want that business?
Saeed agreed, “You’re right. I almost never have to change my delivery schedule because they’ve asked for quick delivery. And they’re right around the corner, so they’re easy for us to get to.”
Tarek continued:
I think about some of our other customers. They seem to never be able to anticipate that they’ll be out of stock. Then they call us and make it our problem to deal with. It seems like we have some customers that we work on all day every day. Why can’t that competitor go after those customers? It’s hard for me to believe that some of those customers arc more profitable than LuLu. Maybe we ought to add what we guys in the warehouse call a “pain facto?’ onto those other customers and then see who is most profitable for us.
As Hamdan listened, he realized Tarek might be onto something. “Jim, what types of costs are included in those customer service costs?”
Tamara replied, “Well, that number includes several things.” He continued: It includes anything related to handling the Milks, like picking the Milks from the storage according to the order instructions, moving the Milks over to the dock, and loading them on the delivery truck. It includes any costs related to taking, coordinating, and administering the orders, like what we pay the people in the sales office who take phone orders from customers, the supervisory costs to administer the order, and similar things. It includes anything related to delivering the Milks to the customer’s location, like the cost of the delivery trucks, truck maintenance, and what we pay Ali and people like him to drive the trucks. It includes anything related to all those rush orders you’re talking about, like overtime, extra scheduling, and stuff like that. And it includes what we pay Bassam for what she does, like visiting the customers to check in on them. So there’s quite a bit of stuff in there.
Hamdan thought about this. “So you’re telling me that there are some customers that you are spending a lot more time on than others? And it’s not LuLu?’
“That’s right,” Tarek replied.
Hamdan continued, “But since our accounting system is allocating these customer services costs based on revenues, and since LuLu is one of our biggest customers, it’s allocating a large share of those costs to LuLu.”
“Exactly,” Tamara said.
Let me do this: Let me spend a couple of days collecting some information. I’ll need some help from each of you because I want to try to find out how much of your time you are spending on each of our customers. Maybe it is time to get more sophisticated about how we look at these customer service costs.
It may be worth the effort.
Saeed, Bassam, and Tarek all agreed to spend some time with Tamara so he could summarize the amount of activity they devoted to each customer. They would meet again the following Thursday. Tamara promised to compile an analysis that might help them determine how profitable each of theft customers really was.
Activity Analysis:
Before he left for the weekend, Tamara decided to pull together some information about the customer services costs he had described in the meeting: handling the product, taking the orders, delivering the product, expediting rush orders, and visiting the customer. She searched through the accounting system and determined how much of the annual $1.8 million in customer services costs were associated with each of those categories (Table 1). Then, on Sunday, ‘Tamara met individually with Saeed, Bassam, and Tarek. With their help, she determined what she thought to be the primary driver of the costs in each of those customer services costs categories.
Tamara determined from the company’s accounting records that the company sold 1,200,000 cases of Milks and processed 750 purchase orders the previous year. Saeed checked the mileage records for the delivery vehicles and determined that the vehicles had travelled a total of 67,200 miles. Tarek was able to determine that the company made 6,720 deliveries, 3,750 of which were expedited deliveries. And finally, Bassam checked her daily travel log to determine she had made a total of 540 sales visits to the company’s customers.
Table: Customer service costs during the prior year by area of activity.
Area of activity Cost driver Cost pool Cost driver
quantity
Product handling Number of cases sold $1,008,000 1,200,000
Taking orders from customers Number of purchase orders $150,000 750
Delivering the product Number of miles travelled $210,000 67,200
Expediting deliveries (other than
automobile)
Number of expedited
deliveries
$297,000 3,750
Sales visits to customers Number of visits $135,000 540
Total $1,800,000
Tamara’s next step was to determine how much of these cost drivers were attributable to each customer. Again, she was able to obtain some of that information (e.g., number of cases) relatively easily from the company’s records. Then her colleagues helped her determine customer numbers for the rest of the activities. Exhibit 2 presents this data for the four customers included in Tamara’s first report (Exhibit 1).
Exhibit (2): Additional Information from Prior Year for Four Customers
LuLu Carrefour Almira Convenient stores Total
Price per case $14.6 $14.9 $15.19 $15.15 $15.0
Number of cases 120,000 120,000 12,000 45,000 1,200,000
Number orders 24 60 30 45 750
Number delivers 165 600 300 345 6,720
Miles travelled per customer 825 11,400 3,300 1380 67,200
Number of expedited delivery 15 375 195 135 3,750
Number of sales visits 18 38 27 13 540
Requirements:
Your have been invited by the management of Almarai to present an overview of the issues facing the company. You are required to write a report to the management of ALMARAI, addressing the issues shown below.
A. The management of ALMARAI are concerned about there relevance of its current costing and billing systems:
1. Write an executive summary to highlight the main themes indicated in ALMARAI case.
2. Describe the main features of the current costing and billing systems used by ALMARAI? Your answer should include the weaknesses of the current costing system.
B. The management of ALMARAI notes that cost accuracy is crucial for product pricing and customer retainment. You have been asked to address the following issues in your report:
1. Use the information in the case, including Exhibit1and 2 and any other necessary data on activities and costs to propose a more relevant costing system for ALMARAI. Use the costing system you have proposed to allocate ALMARAI’s overhead costs.
2. Explain the differences in the assumptions between ALMARAI’scurrent costing system and the costing system you have recommended in (B.1) above.
3. Use the costing system information calculated in (B.1) above to estimate customer profitability for LuLu, Carrefour, Almira and convenient stores.
4. Compare the costs and profit per customer you have calculated using your recommended costing system (B.3) and the estimated costs using ALMARAI’s current costing system:
a. What causes the two costing systems to provide different cost estimates?