Case study: R&V Fashion

Case study: R&V Fashion

Kate Wang, the General Manager of R&V Fashion, is concerned about the financial results for the calendar 2016. Despite a sales increase from the prior year, the company had just suffered the first loss in its history, as shown in the summary income statement below:

R&V Fashion

Income Statement for Financial Year ended 31 December 2016

Sales 42 500 000 121.4%
Cost of goods purchased 35 000 000 100%
Gross margin (gross profit)   7 500 000 21.4%
Warehouse personnel expenses   2 400 000 6.9%
Warehouse expenses (excluding personnel)   2 000 000 5.7%
Freight      450 000 1.3%
Delivery Van expenses       200 000 0.6%
Order entry expenses       800 000 2.3%
General and administrative expenses   2 000 000 5.7%
Interest expense       120 000 0.3%
Net profit (before taxes)     (470 000) -1.3%

 

R&V Fashion is a distributor of premium men’s and women’s fashion labels to department stores and specialty boutiques throughout Australia and New Zealand. It works closely with suppliers and clients aiming to provide clients with uncomplicated delivery of sought after brands. This offering, coupled with personalized service differentiates the company in a highly competitive market.

 

R&V Fashion operates several distribution centres in which personnel unloaded truckload shipments of products from suppliers, and moves the cartons into designated storage locations until customers request the items. Each day, after customer orders have been received, R&V Fashion personnel drives forklift trucks around the warehouse to accumulate cartons of items and prepares them for shipment.

 

R&V fashion, usually ships its products to its customers using commercial truckers. Recently, however, the company has started offering a “drop-ship” option by delivering the products directly to individual locations at the customer’s site, which has attracted new business. R&V Fashion operates a small fleet of vans and assigns warehouse personnel as drivers to make the drop-ship deliveries. R&V Fashion charges a small price premium (up to an additional 2% markup) for the convenience and savings such direct delivery orders provide to customers. The company believes that the added price for this service could improve margins in its highly competitive business.

 

R&V Fashion orders its goods from several suppliers. It prices products to its customers by first marking up the purchased product cost by about 15% to cover the cost of warehousing, distribution, and freight. Then it adds another markup to cover the cost for general and selling expenses, plus an allowance for profit.

 

R&V Fashion also has introduced an electronic data interchange and up–to-date internet site that allows customer orders to arrive automatically so that clerks do not have to enter customer and order data manually. Several customers have switched to this electronic service because of its convenience.

 

Despite being highly competitive, R&V Fashion’s costs continue to rise. Wang is concerned that even after introducing innovations such as the drop-ship delivery and the electronic order entry, the company is not earning profit! She wonders what to do to become profitable again.

 

Wang called her management accountant, Shanta Davies and director of operations Dev Patel for help. Dev suggested to check discreetly what is going on in the distribution centres and get a clearer picture about what it costs to serve their various customers.

 

Shanta and Dev went into the field to gather more information. They visited one of R&V fashion’s distribution facilities. The site manager, Mr. Murakami, confirmed: “All we do is store the cartons, process the orders, and ship them to the customers”. With Mr. Murakami’s help, Shanta and Dev identified four primary activities done at the distribution centre:

  1. Process cartons in and out of the facility
  2. The new drop-ship delivery service
  3. Order handling
  4. Data entry

 

Mr. Murakami described some details of these activities:

“The amount of warehouse space we need and the people to move the cartons in and out of storage and get them ready for shipment just depends on the number of cartons. All items have about the same inventory turnover so space and handling costs are proportional to the number of cartons that go through the facility.

We use commercial freight for normal shipments, and the cost is based more on volume than on anything else. Each carton we ship costs about the same, regardless of the weight or distance. Of course, any carton we deliver ourselves, through our new drop-ship delivery service, avoids the commercial shipping charges”.

The team confirmed the information with the warehouse supervisor, who noted: “This drop-ship delivery is a real problem for my people. Sure, we offer the service, and it has attracted more customers. But I have had to add people since existing personnel already had more than enough to do!”.

 

Shanta and Dev next checked on the expenses of entering and validating customer order data. The order entry expenses included the data processing system and the data entry operators. They spoke to Jason Li, a very experienced data entry operator at R&V Fashion: “All I do is key in the orders, line by line. I start by entering the customer ID and validating our customer information. Beyond that, the only thing that really matters is how many lines I have to enter. Each line item on the order has to be entered separately. Of course, any order that comes in through our new EDI system or internet page sets up automatically without any intervention from me. I just do a quick check to make sure the customer hasn’t made an obvious error, and that everything looks correct. This validity check takes about the same time for all electronic orders; it doesn’t depend on the number of items ordered”.

 

Shanta and Dev collected information from the company databases and via interviews to estimate the amount of time people spent on the various activities they had identified, and learnt the following:

 

  • The distribution centres processed 80,000 cartons in year 2016. Of these, 75,000 cartons were shipped by commercial freight. The remaining 5,000 cartons were delivered under the drop-ship delivery options. R&V Fashion made 2,000 drop-ship deliveries during the year.
  • People felt this total amount of handling, processing and shipping was about the capacity that could be handled with existing resources.
  • The data entry operators processed 16,000 manual orders, and validated 8,000 EDI orders. The 16,000 manual orders had an average of nearly 10 items per order, or 150,000 order lines in total. As with the carton handling, shipping, and delivery personnel, supervisors felt that the data entry operators were operating at capacity rates with the existing business.
  • 90% of the workers processed cartons in and out of the facility. The remaining 10% of workers were assigned to the drop-ship delivery service.
  • All of the other warehouse expenses (rent, building and equipment depreciation, utilities, insurance, and property taxes) were associated with the receipt, storage, and handling of cartons.
  • The delivery vans were used only for drop-ship delivery orders
  • With regard to data entry, the operators worked 10 000 hours during 2016. Further analysis of the records revealed the following distribution of time for each of the activities performed by data entry operators:
Activity Data Entry Operators time
Set up manual customer orders 2 000 hours
Enter individual order lines in an order 7 500 hours
Validate an EDI/internet order     500 hours
Total 10 000 hours

 

 

Shanta looked through the customer accounts and found two typical accounts of similar size and activity volume. Customers A and B had each generated sales in year 2016 slightly above $100,000. The costs of the products ordered were also identical at $85,000. The overall markups (21.2% for Customer A, and 22.4% for B) were in the range of markups targeted at R&V Fashion. The markup for Customer B was marginally higher due to premium charges for drop-ship deliveries. Both customers had ordered 200 cartons during the year. The existing customer profitability system (see table below) indicated that both customers generated a contribution margin sufficient to cover normal general and selling expenses and return a profit for the company.

 

 

Customer Profitability Report
  Customer A Customer B
Sales 103 000 121.2% 104 000 122.4%
Cost of goods purchased   85 000 100.0%    85 000 100.0%
Gross margin (gross profit)   18 000 21.2%    19 000 22.4%
Warehousing, distribution and order entry    12 750 15.0%    12 750 15.0%
Contribution to general and administrative expenses, and profit      5 250 6.2%       6 250 7.4%

 

Shanta noticed, however, that the two accounts differed on the service demands made on the company. Customer A placed a few large orders, and started using EDI to place its orders (half its orders, in year 2016, arrived electronically). Customer B, in contrast, placed many more orders, so its average size order was much smaller than for Customer A. Also, all of Customer’s B orders were either paper or phone orders, requiring manual data entry; and 25% of B’s orders requested the drop-ship delivery option.

 

Shanta, concerned about increases in R&V Fashion’s borrowings from the bank, also noticed that Customer A generally paid its bills within 30 days, while Customer B often took 90 days or more to pay its bills. A quick study revealed that the average accounts receivable balance during the year for A was $9 000, while for B it was $30 000. With R&V Fashion paying interest at 10% per year on its working capital line of credit, Shanta thought this difference may be significant.

The following table shows Shanta’s summary of the actual ordering, delivery and payment statistics for the two customers. She believed that she was now ready to assess the actual profitability of customers, and make recommendations about how to reverse R&V fashion’s recent profit slide.

Services Provided in Year 2016 to Customers A and B
  Customer A Customer B
Number of cartons ordered 200 200
Number of cartons shipped by commercial freight 200 150
Number of drop-ship deliveries 25
Number of orders, manual 6 100
Number of line items, manual 60 180
Number of EDI orders 6
Average accounts receivable $9 000 $30 000

 

Required:

Write a report written from the point of view of the management accountant directed to the general manager in which you answer the following questions:

  1. Why is R&V Fashion’s existing pricing system inadequate for its current operating environment?
  2. Develop an activity-based cost system for R&V fashion based on year 2016 data. Calculate the activity cost driver rate for each R&V Fashion activity in 2016. The activities are as follows:

Ship cartons; process cartons (we define two different activities, process cartons and ship cartons because they handle different quantities of the activity driver, as 75 000 cartons are shipped via freight and 5 000 cartons are shipped via drop-ship delivery); drop-ship delivery; set-up manual order; enter items ordered (individual order lines in an order); validate EDI order.

 

  1. Using your answers to question 2, calculate the profitability of Customer A and Customer B.
  2. What explains any difference in profitability between the two customers?
  3. Explain:
    1. What are the limitation, if any, to the estimates of the profitability of the two customers?
    2. What are the advantages and the limitations of Activity-based costing?

 

Please note: The marking rubrics for the written report is provided in a separate document.

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