Costing Techniques and Profitability Analysis Harvard Case Solution & Analysis

Suggestions to the Executive Team to Improve the Profitability

Analysis of cost structure, activities and cost drivers reveals that sales representatives entertain sales order of only one category of customers and sales representative, who entertains pharmacy customers process 4,000 orders per representative; whereas, sales representatives take care of grocery customers by processing 1,000 sales orders per representative, which shows that representatives who serve grocery customers are underutilized; therefore, executive is suggested to decrease the number of sale representatives and train each representative so that he can process orders of any category of customers and in this way executive team can cut selling cost in order to improve profitability.

Moreover, shipping cost is very much high for both pharmacy category customers and grocery customers, meanwhile, number of deliveries are higher than the number of sale orders placed; which means that order are being delivered in partial deliveries that increase the cost of shipping. Therefore, management should take initiatives to decrease number of sales orders and number of deliveries and in order to do this, the management can offer discounts to customers for large orders and deliveries should be shipped as per sales orders.

Furthermore, activity based costing system reveals that pharmacy category customers are making losses but straight away abandonment of pharmacy category is not a suitable option because currently pharmacy category is generating contribution of $11.76 million and total overheads allocated to pharmacy category using activity based costing system is amounted to $17.58 million; therefore, abandonment of pharmacy category customers will increase overall losses from $5.812 million to $11.76 million. Meanwhile, more detailed analysis of cost structure reveals that sales representative’s cost of $2.88 million can be avoided if a decision to abandon pharmacy category is taken but still it will not eliminate overall losses. Therefore, executive management should not abandon its sales to pharmacy customers but it should focus on cost reduction strategies as suggested above in order to increase profitability.

EXHIBIT


Estimated Use of Labor Hours
    
Estimated Use of Labor Hours

32,000

32,000

32,000

32,000

Number of Units Produced

200,000

200,000

200,000

200,000

Number of Units Sold

150,000

160,000

170,000

180,000

Total Overheads

(4,000,000)

(4,000,000)

(4,000,000)

(4,000,000)

Pre-Determined Overhead Rate

(125)

(125)

(125)

(125)

Revenue

9,000,000

9,600,000

10,200,000

10,800,000

Conversion Cost

(2,250,000)

(2,400,000)

(2,550,000)

(2,700,000)

Applied Overhead

(3,750,000)

(4,000,000)

(4,250,000)

(4,500,000)

Gross Margin

3,000,000

3,200,000

3,400,000

3,600,000

Under/Over-Applied MOH

(250,000)

-

250,000

500,000

Selling & Administrative Expenses

(2,700,000)

(2,700,000)

(2,700,000)

(2,700,000)

Pre-tax Operating Income

50,000

500,000

950,000

1,400,000

     
Expected Capacity of Hours    
Expected Capacity

40,000

40,000

40,000

40,000

Number of Units Produced

200,000

200,000

200,000

200,000

Number of Units Sold

150,000

160,000

170,000

180,000

Total Overheads

4,000,000

4,000,000

4,000,000

4,000,000

Pre-Determined Overhead Rate

100

100

100

100

Revenue

9,000,000

9,600,000

10,200,000

10,800,000

Conversion Cost

(2,250,000)

(2,400,000)

(2,550,000)

(2,700,000)

Applied Overhead

(3,000,000)

(3,200,000)

(3,400,000)

(3,600,000)

Gross Margin

3,750,000

4,000,000

4,250,000

4,500,000

Selling & Administrative Expenses

(2,700,000)

(2,700,000)

(2,700,000)

(2,700,000)

Pre-tax Operating Income

1,050,000

1,300,000

1,550,000

1,800,000

     
Profitability Analysis Using Activity-Based Costing Techniques
Customer Types

Pharmacy

Grocery

Herbal Therapist

Total

Revenue

25,514,800

49,399,400

16,085,800

91,000,000

Cost of Goods Sold

13,755,008

30,140,662

10,780,530

54,676,200

Gross Margin

11,759,792

19,258,738

5,305,270

36,323,800

Gross Margin percentage

46.10%

39.00%

33.00%

39.90%

Operating Costs:
Operating Cost
Sales Representatives

2,884,000

721,000

-

3,605,000

Sales Account Managers

-

720,000

-

720,000

Telephone order system

73,239

54,930

1,831

130,000

Sales Administration

252,632

189,474

37,895

480,000

 

3,209,871

1,685,403

39,726

4,935,000

Marketing Costs
Promotions & Incentives

990,000

1,260,000

-

2,250,000

Advertising

1,200,000

1,200,000

-

2,400,000

Catalogue Development

-

-

250,000

250,000

Marketing Management

160,898

180,735

18,367

360,000

 

2,350,898

2,640,735

268,367

5,260,000

Distribution Costs
Company Trucks

5,579,048

2,500,952

-

8,080,000

UPS Service

-

-

1,930,296

1,930,296

 

5,579,048

2,500,952

1,930,296

10,010,296

R&D Costs
Supplements

38,400

398,400

43,200

480,000

Herbal Remedies

36,000

244,800

439,200

720,000

 

74,400

643,200

482,400

1,200,000

General & Administrative Costs

6,361,538

1,060,256

848,205

8,270,000

 
Total Operating Cost

(17,575,755)

(8,530,547)

(3,568,994)

(29,675,296)

 
Total Operating Income

(5,815,963)

10,728,191

1,736,276

6,648,504

 
Return on Sales

-22.79%

21.72%

10.79%

7.31%

...............................

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