Commercial Paper Company Narrative

Case: Commercial Paper Co.
The PFS Business

In 1992, Commercial Paper Co. was a corporation with annual sales of $900 million in
business forms and specialty paper products, such as writing paper, envelopes- note cards, and
greeting cards. In 1988 the company had expanded into business forms inventory management
services. This was an area where Commercial Paper Co. believed it could offer value-added
services to differentiate it from other business forms manufacturers. The forms manufacturing
business was mature by 1988, and all competitors were seeking ways to generate sales growth.
Commercial Paper Co. created PFS for its corporate clients, the services provided under PFS
included warehousing and distribution of forms (including inventory financing). As part of its
distribution services it was offered a "pick pack" service where trained workers actually opened
full cartons to pick the exact number of forms requested by the clients. For a small number of
clients it was also offered "desk top delivery," where PFS personnel would distribute the forms to
individual offices (forms were usually delivered only to the loading dock). Commercial Paper Co.
operated its forms manufacturing and PFS activities as separate profit centers.
Current Cost Accounting System
Clients who participated in the forms management program kept and inventory of forms
at one of PFS’s distribution centers. The forms were distributed to the client as needed. The client
was charged a service fee of 32.2% of the cost of sales to cover the cost of warehousing and
distribution, regardless of the specific level of service provided to that client (see Exhibit 1). The
sales force then marked up the cost of product and services by 20 percent.
EXHIBIT 1: Calculation of Service Fee Charges (000s)
Year Concept Total Cost % of product cost

1990 Product sales at cost $24,059
1990 Warehousing/distribution expense $ 4,932 20.5%
1990 Total cost of inventory financing $ 1,131 4.7%
1990 Total freight charges $ 1,684 7%
Total services costs 32.2%
Standard price (Product cost x 1.32) x 1.2
Understanding Customer Profitability
With PFS profitability suffering in October 1992, General Manager John Malone began
to question the appropriateness of the distribution charges. "PFS in 1988 earned a 20 percent
Return on Investment (ROI). But returns have been dropping for several years. PFS is projected
to earn an ROI of only 6 percent for 1992. Something tells me that we are not managing this
business very well! It seems to me that the charge for services needs closer scrutiny. I believe we
should charge our clients for the services they use. It doesn't seem fair that if two clients buy the
same amount of product from us, but one keeps a lot of inventory at our distribution center and is
constantly requesting small shipments and the other hardly bothers us at all, both should pay the
same service fees."
John looked through his records and found two accounts of similar size, accounts A and
B, which were handled by different sales people. Accounts A and B both had annual sales of
$79,320 with the cost of the product being $50,000. In the past year, customer A had submitted
364 requisitions for product with a total of 910 lines 1 (all of them "pick-pack") while customer B
had submitted 790 requisitions with a total of 2500 lines (all "pick-pack"). Customer A kept an
average of 350 cartons of inventory at the distribution center while customer B kept 700 on
average. Customer B's average monthly inventory balance was $50,000 while that of customer A
was only $15,000. Because of the greater activity on customer B's account, a shipment went out
three times a week at an annual freight cost of $7,500 while Customer A required only one
shipment a week at an annual freight cost of $2,250. In addition, customer B had requested desk
top delivery 26 times during the past year, while customer A did not request desk top delivery at
all.
Distribution Center: Activity Analysis
Two primary activities took place in the distribution centers -the warehousing of forms
and the distribution of those forms in response to a customer requisition. For the administration of
the operation, everything depends on the number of requisitions. On a given requisition, the
customer can request as many different items as they like. Each distribution center is made up by
six primary value-added activities: storage, requisition handling, basic warehouse stock selection,
"pick-pack" activity, data entry, and desk top delivery. The costs assigned to these activities are
as follows (see Exhibit 2):
EXHIBIT 2: Breakdown of Expenses by Activity (000s)
Total Expense Activity Costs *

Rent (85%) $1,424 x 0.85 $1,211
Depreciation (85%) $ 208 x 0.85 $ 177
Utilities (85%) $ 187 x 0.85 $ 159
Security $ 3 $ 3
Total storage expense $1,550
Rent (15%) $1,424 x 0.15 $ 214
Depreciation (15%) $ 208 x 0.15 $ 31
Utilities (15%) $ 187 x 0.15 $ 28
Salaries & fringes $ 909 $ 909
Telephone $ 96 $ 96
Taxes/insurance $ 104 $ 104
Travel/entertainment (75%) $ 40 x 0.75 $ 30
Postage $ 56 $ 56
Hourly payroll & fringes $ 316 $ 316
Temp help $ 17 $ 17
Total requisition handling expense $1,801
Variable warehouse pay & fringes $1,735 $1,735
Travel and entertainment (25%) $ 40 x 0.25 $ 10
Total warehouse activity (to be distributed among 3 activities) $1,745
Basic warehouse stock selection (44%) $ 761
“Pick pack" activity (42%) $ 734
Desktop delivery (14%) $ 250
Data Processing expense $ 612 $ 612
Total $5,708 $5,708
*Some expense items were allocated between activities.
1
Whenever a customer requires forms, they submit a requisition for all the different products they need.
Each separate product request is a "line." If the request is for whole cartons, it is considered a "carton line."
For quantities less than a whole carton, it is considered a "Pick-pack line".
It is estimated for the distribution centers in the year 1992 that, on average, they will have
inventories of approximately 350,000 cartons, they will process about 310,000 requisitions, that
each requisition will average 2.5 lines, that about 90 percent of the lines will require "pick-pack"
activity (as opposed to shipping an entire carton), that the cost of capital will be about 13 percent,
that the computer system will track individual freight charges and that 8,500 'desk top' requests
will be processed. With all that information the controller calculated the cost of service activities
(see exhibit 3).
EXHIBIT 3: Activity Based Costs – Calculation of Service Costs
Value Added Total FY92 Expense Cost Driver Cost Driver Service Cost
Activities Defined as: per activity (000) Defined unitsFY92 per year
Storage $1,550 Cartons in Inv. $350,000 $4.43
Requisition Handling 1,801 Requisitions 310,000 $5.81
Warehouse Activity 761 Carton Lines 775,000 $0.98
Pick Packing 734 (PP) Lines 700,000 $1.05
Data Entry 612 Carton Lines 775,000 $0.79
Desk Top Delivery 250 Per Time 8,500 $29.42
$5,708
Freight Charge Actual Cost
Inventory Finance Inventory Value x Capital Charge*
* Assume Cost of Capital = 13.5% given that prime rate is 10%
Services Based Pricing (SBP)
The entire management team felt that there had to be a better way of charging out distribution
services to help PFS become more profitable. They now had a much better understanding of the
drivers of costs involved in distribution services. Although PFS maintained 1100 separate
accounts, a large portion of the business came from very few accounts. The top 40 accounts
represented 48 percent of the company's net sales (see Exhibit 4).
Since such a large part of the profit opportunity rested with so few accounts, management felt that
it might be possible to significantly improve profitability by concentrating on individual account
management. The team felt they were on the right track for improving account profitability and
wondered what should be the next step. They also wondered what other issues might be important
for improving the overall profitability of PFS.
EXHIBIT 4: PFS Net Sales, 1991
Annual Sales/ Account Number of Accounts % of PFS Net Sales

> $ 300,000 40 48%
> $150,000 53 19
> $ 75,000 86 15
> $ 30,000 143 11
> $0 778 7
Total 1,100 100%
Required:
The top management team asked you, an external consultant, to 1) identify the reasons for profit
problems through quantitative and qualitative analysis, 2) calculate and comment on the
distribution services costs for "Customer A" and "Customer B." using ABC, and 3) recommend
solutions for the company to improve profitability.
Questions (to guide your analysis)
1. Using the information in the text calculate "ABC"-based services costs for the PFS business.
2. Using your new costing system, calculate distribution services costs for "Customer A"
and "Customer B."
3. What inference do you draw about the profitability of these two customers?
4. Should PFS implement the SBP pricing system?
5. What managerial advice do you have for Commercial Paper Co. about the Personalized
Forms Services (PFS) business? How does Exhibit I relate to this question?

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Case: Commercial Paper Co.

The PFS Business

Current Cost Accounting System

EXHIBIT 1: Calculation of Service Fee Charges (000s)

Year Concept Total Cost % of product cost

Understanding Customer Profitability

Distribution Center: Activity Analysis

EXHIBIT 2: Breakdown of Expenses by Activity (000s)

Total Expense Activity Costs *

EXHIBIT 3: Activity Based Costs – Calculation of Service Costs

Services Based Pricing (SBP)

EXHIBIT 4: PFS Net Sales, 1991

Annual Sales/ Account Number of Accounts % of PFS Net Sales

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