Johnson Beverage Case

1.
Allocation Rates Based on Activities

Area of Activity Activity Cost Cost Driver Allocation Rate

Product handling
Taking orders from
customers
Delivering the product
Expediting deliveries
Sales visits to
customers
672,000 / 800,000 =
$672,000 Number of cases sold $0.84 per case sold
Number of purchase 100,000 / 500 =
$100,000 $200 per purchase order
orders
140,000 / 44,800 =
$140,000 Number of miles traveled $3.125 per mile traveled
Number of expedited 198,000 / 2500 =
$198,000 $79.20 per expedited delivery
deliveries
90,000 / 360 =
$90,000 Number of sales visits $250 per sales visit

Four Customers’ Customer Service Costs, as Calculated with Activity-Based Cost System

Midwellen
Saver Superstore Oscar’s OddLots Downtown Retail
Supermarket
.84 * 80,000 = .84 * 80,000 = .84 * 8000 = .84 * 30,000 =
Product handling $67,200 $67,200 $6720 $25,200
Taking orders 200 * 16 = 200 * 40 = 200 * 20 = 200 * 30 =
from customers $3200 $8000 $4000 $6000
Delivering the 3.125 * (110 * 5) = 3.125 * (400 * 19) = 3.125 * (200 * 11) = 3.125 * (230 * 4) =
product $1718.75 $23,750 $6875 $2875
Expediting 79.2 * 10 = 79.2 * 250 = 79.2 * 130 = 79.2 * 90 =
deliveries $792 $19,800 $10,296 $7128
Sales visits to 250 * 12 = 250 * 25 = 250 * 18 = 250 * 9 =
customers $3000 $6250 $4500 $2250
Total Allocated
Customer $75,910.75 $125,000 $32,391 $43,453
Service Cost

Four Customers’ Profitability, as Calculated with Activity-Based Cost System

 Saver Oscar’s Midwellen Downtown
Superstore OddLots Supermarket Retail
Net Revenues $1,168,000 $1,192,000 $121,520 $454,500
Cost of Goods 1,048,000 1,048,000 104,800 393,000
Gross Margin $120,000 $144,000 $16,720 $61,500
Customer service costs 75,910.75 125,000 32,391 43,453
Customer profit $44,089.25 $19,000 ($15,671) $18,047
Customer profit (% of
3.77% 1.59% (12.90%) 3.97%
net revenues)

Under an activity-based cost system, Saver Superstore generates $44,089.25 in profit for the
Johnson Beverage Company; Oscar’s OddLots and Downtown Retail respectively produce
profits of $19,000 and $18,047. Midwellen Supermarket, on the other hand, fails to provide the
company with any profitability and instead lowers the bottom line by $15,671.

2.
Four Customers’ Costs and Profitability: Current1 vs. Activity-Based Cost System

Saver Superstore Oscar’s OddLots

Activity- Activity-
Cost System Current Difference Current Difference
Based Based
Customer
$116,800 $75,910.75 40,889.25 $119,200 $125,000 -5800
service costs
Customer profit $3200 $44,089.25 -40,889.25 $24,800 $19,000 5800
Customer profit
(% of net 0.3% 3.77% -3.47% 2.1% 1.59% 0.51%
revenues)
Midwellen Supermarket Downtown Retail
Activity- Activity-
Cost System Current Difference Current Difference
Based Based
Customer
$12,152 $32,391 -20,239 $45,450 $43,453 1997
service costs
Customer profit $4568 ($15,671) 20,239 $16,050 $18,047 -1997
Customer profit
(% of net 3.8% (12.90%) 16.7% 3.5% 3.97% -0.47%
revenues)
The current cost system causes the Johnson Beverage to overestimate both Saver
Superstore and Downtown Retail’s customer service costs; whereas Downtown Retail’s

1
Current cost system uses the company’s total sales revenue as its sole cost driver in allocating overhead costs.
customer service costs are $1997 lower under the activity-based cost system, Saver Superstore’s
costs are lowered by nearly $41,000. The difference between the cost systems raises Saver
Superstore’s profitability by a significant 3.47%, while that of Downtown Retail increases by
0.47%. In contrast, the current system underestimates the customer service costs of Oscar’s
OddLots and Midwellen Supermarket by $5800 and $20,239, respectively. Oscar’s Oddlots
profitability falls by 0.51%, while Midwellen Market’s profit contribution falls by a substantial
16.7% for a net loss of 12.9%.
Under the current system, Johnson Beverage uses its net revenue as the sole base for
allocating customer service costs, resulting in a company-wide allocation rate of $0.10 per dollar
of revenue2. In contrast, under an activity-based cost system, the company first groups related
customer service activities into five different activity centers and then assigns a portion of the
overall customer service cost to each activity center; for example, costs related to taking,
coordinating, and administering orders from customers are pooled together under the “Taking
orders from customers” activity center, which is then assigned a cost of $100,000. Johnson
Beverage then determines the cost drivers of each activity center, using both volume- and
activity-based cost drivers, and calculates an allocation rate for each area of activity. The
company then proceeds to compute the customer service costs that it is incurring for individual
customers, using multiple allocation rates rather than the single rate of its traditional costing
system.
Whereas the current cost system of Johnson Beverage only takes a customer’s sales
revenue into account, the activity-based system includes a variety of activities and corresponding
cost drivers. Discrepancies therefore arise between the two cost systems: the current system
assumes that only sales revenues drive a customer’s service costs, while the activity-based
system assumes that five different activities determine a customer’s service costs, therefore
resulting in further cost variation and the different results between the cost systems.
The activity-based cost system provides Johnson Beverage with more accurate
information since it traces multiple cause-and-effect relationships, while the current system relies
on only such relationship. Under its current cost system, customers’ net revenues are the sole
driver of the customer service cost they present to Johnson Beverage; however, such an
assumption is highly inaccurate, given the range of activities associated with customer service
costs. For example, while sales revenues may correspond with product handling costs to some
extent, they cannot be the sole cost driver of overall customer service costs because other
activities, such as expedited deliveries and sales visits made by the company representative, are
essentially unrelated to sales revenues (eg. a customer may have high net revenues, but make
very few expedited requests; a customer with low net revenues may require numerous sales
visits). Therefore, by examining multiple activities and not relying on a lone volume-based cost
driver, which does not influence all customer service costs, an activity-based cost system
produces more accurate information than the company’s current cost system.

2
Current allocation rate = $1,200,000 customer service cost / $12,000,000 sales revenue = $0.1 per dollar of revenue
3. Since customer service costs make up a significant portion3 of overall company costs and
ultimately have a major role in determining a customer’s profitability (as evidenced by the sharp
decrease from gross margin to customer profit), the management of Johnson Beverage should
aim to use a very accurate costing system for the allocation of these costs. The company should
therefore strongly consider replacing its current cost system with activity-based costing, which is
a system that has provided more accurate information because of its use of multiple activity
centers and corresponding cost drivers.
As evident in the results of both cost systems, by using a single customer service
allocation rate, Johnson Beverage has over- and under-costed many of its customers. For
example, the company has so highly undercosted Midwellen Market that the customer’s sales
revenue cannot even cover its costs to the company, resulting in a loss of profit. Saver
Superstore, on the other hand, has been overcosted, resulting in unexpectedly high profit for the
company. Yet this overcosting has also resulted in the customer’s current demands for lower
prices, posing a problem for management, which has been led by its current cost system to
believe that Saver Superstore will present a loss if it receives any lower of a price on cases
(under the current cost system, Saver Superstore’s profitability only is 0.3%). By improving the
accuracy of its cost allocations through activity-based costing, Johnson Beverage would lower
the severity of or possibly eliminate the undercosting and overcosting that has prevented it from
reaching potential profits with some customers while damaging its relationship with others.
In regard to the specific problem that management faces regarding Saver Superstore, a
sensible decision would indeed be to lower the price it charges the store per case. Under the
activity-based cost system, Saver Superstore is costing Johnson Beverage about $14.054 per case,
$0.55 lower than the price it is paying. While it would not be wise to the lower the price to
nearly break-even (doing so would lower the company’s overall profit), negotiating a price
slightly under the current price of $14.60 would present Johnson Beverage with more benefits
than losses, with the primary benefit being that it would retain a customer with high sales volume
and relatively low costs. Were it to lose Saver Superstore as a customer, some customer service
costs would likely be allocated to other customers, thereby decreasing profits as revenues would
decrease significantly more than costs. For example, the company’s sales representative may be
forced to visit other customers more frequently following the loss of such a large customer; costs
related to sales visits would therefore not be eliminated by the absence of Saver Superstore, but
simply re-allocated to other customers.
After implementing an activity-based cost system, management may wonder if it should
eliminate customers that pose a loss to the company, such as Midwellen Supermarket. While
doing so may at first sound reasonable, the company must first take into account that such
customers are providing revenues that help cover overall customer service costs and therefore
actually prevent the bottom line from falling further. For example, some costs pooled under
“Product delivery”, such as the cost of delivery trucks and truck maintenance, would likely
remain the same regardless of whether Johnson Beverage serves Midwellen Market; therefore, if
this customer were to be eliminated, the company’s product delivery costs would only be
distributed among less customers, while net revenues would decrease—thereby decreasing the
bottom line. Johnson Beverage therefore has to analyze which area of activity harbor product
and facility-level costs, which are incurred regardless of the number of customers served, before
deciding to eliminate a customer who fails to provide profit to the company.

3
10.27% of total costs [1,200,000 / (1,200,000 + 10,480,000)]
4
(75,910.75 + 1,048,000) / 80,000 cases = 14.0488
 An activity-based cost system would also call to attention which customer service costs
Johnson Beverage should work to lower or even eliminate.

Sales visits to
Product Taking orders Delivering the Expediting
customers
handling from customers product deliveries
Total
$672,000 $100,000 $140,000 $198,000 $90,000
Cost

Since product handling accounts for over half of all customer service costs, management would
likely first work to lower costs pooled under this area of activity. For example, less time-
consuming methods could be developed for following order instructions (possibly through more
advanced technology), while higher-quality equipment could eliminate the amount of manpower
needed to transport the beverage to the truck. Expedited deliveries also make up a major part of
customer service costs; Johnson Beverage could offset some of these costs by charging a
premium on such orders. The number of sales visits performed by the company representative
could also be lowered; for example, the company could experiment with teleconferencing and
other means of sales communications to customers. Order taking costs could be lowered by
eliminating the need for supervisors through better training of the employees who take the
orders. Such measures could ultimately help Johnson Beverage lower its customer service costs,
which make up a significant amount of overall costs, and therefore increase its net profit.