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Chapter 18 Additional Aspects of Product Costing Systems 567

EXHIBIT 1 Forecasted Monthly Sales and Production Plan

Valves Pumps Flow Controllers Total

Forecasted Price $75 $80 $110
Forecasted Sales (units) 10,000 12,000 2,500 24,500

Number of production runs 40 40 50 130

Number of shipments 40 70 100 210
Total DL hours 3,800 6,000 1,000 10,800
Setup labor hours/run 4.0 4.8 9.6
Total setup hours 160 192 480 832
Machine hours: run + setup 5,160 6,192 1,230 12,582
Engineering hours 60 240 400 700
Source: Casewriter.

Productivity expiration times; Knight believed she could, on short

• Reduce setup times. notice, make 10%–15% adjustments up or down to ac-
commodate changes in demand for machine capacity.
Based on the new strategy, Peggy Knight developed
Also, Knight felt that she had some flexibility with the
the forecasted monthly sales and production plan
size and composition of the labor force. The company
shown in Exhibit 1. She wondered whether the shift in
had recently hired quite a few production employees
product mix, new pricing model, and forecasted pro-
on short-term contracts to meet the expanded demand
ductivity improvement in setup times would be suffi-
for the newly introduced flow controller line.
cient to restore Sippican’s historic margins. Sippican’s
machines were leased monthly and had staggered

Case 18–6
Midwest Office Products*
John Malone, general manager of Midwest Office for modern high-speed copiers and printers. MOP
Products (MOP), was concerned about the financial had an excellent reputation for customer service and
results for calendar year 2003. Despite a sales increase responsiveness.
from the prior year, the company had just suffered the Warehouse personnel at MOP’s distribution center
first loss in its history (see summary income statement unloaded truckload shipments of products from manu-
in Exhibit 1). facturers, and moved the cartons into designated stor-
Midwest Office Products was a regional distributor age locations until customers requested the items.
of office supplies to institutions and commercial busi- Each day, after customer orders had been received,
nesses. It offered a comprehensive product line rang- MOP personnel drove forklift trucks around the ware-
ing from simple writing implements (such as pens, house to accumulate the cartons of items and prepare
pencils, and markers) and fasteners to specialty paper them for shipment.
MOP ordered supplies from many different manu-
facturers. It priced products to its end-use customers
*Professor Robert S. Kaplan. by first marking up the purchased product cost by
Copyright © President and Fellows of Harvard College. 16% to cover the cost of warehousing, order process-
Harvard Business School case 104-073. ing, and freight. Then it added another 6% markup to
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EXHIBIT 1 Midwest Office Products: Income Statement, January–December 2003

Sales $42,700,000 122.0%

Cost of Items purchased
______________________ 35,000,000
_____________ _100.0%
_______
Gross margin 7,700,000 22.0%
Personnel expense (warehouse, truck drivers) 2,570,000 7.3%
Warehouse expenses (excluding personnel) 2,000,000 5.7%
Freight 450,000 1.3%
Delivery truck expenses 200,000 0.6%
Order entry expenses 840,000 2.4%
General and selling expenses 1,600,000 4.6%
Interest expense
_______________ 120,000
_____________ ____0.3%
____
Net income before taxes $ (80,000) (0.2)%
Source: casewriter

cover the general, selling, and administrative ex- innovations such as desktop delivery and electronic
penses, plus an allowance for profit. The markups order entry, the company could not earn a profit. He
were determined at the start of each year, based on wondered about what actions he should take to regain
actual expenses in prior years and general industry profitability.
and competitive trends. Midwest adjusted the actual
price quoted to a customer based on long-term
relationships and competitive situations, but pricing
was generally independent of the specific level of ser- Distribution Center: Activity
vice required by that customer, except for desktop Analysis
deliveries.
Typically, MOP shipped products to its customers Malone turned to his controller, Melissa Dunhill, and
using commercial truckers. Recently, MOP had in- director of operations, Tim Cunningham, for help. Tim
troduced a desktop delivery option in which suggested:
Midwest personnel personally delivered supplies di-
rectly to individual locations at the customer’s site. If we can figure out, without going overboard of
Midwest had leased four trucks and hired four dri- course, what exactly goes on in our distribution
vers for the desktop delivery service. Midwest center, maybe we can get a clearer picture about
charged a price premium (up to an additional 5% what it costs to process orders and serve our
markup) for the convenience and savings such direct customers.
delivery orders provided to customers. The company
believed that the desktop delivery option would Distribution center manager, Wilbur Smith, spoke
improve margins and create more loyal customers in with Melissa and Tim about the operations at the
its highly competitive office supplies distribution center:
business. All we do is store the cartons, process the orders,
Midwest had introduced electronic data inter- and get them ready to ship to customers, either by
change (EDI) in 1999, and a new internet site in commercial freight or using the desktop delivery
2000, which allowed customer orders to arrive auto- option.
matically so that clerks would not have to enter data Wilbur described some details of these activities:
manually. Several customers had switched to this
electronic service because of the convenience The amount of warehouse space we need and the
to them. Yet Midwest’s costs continued to rise. people to move cartons in and out of storage and
Malone was concerned that even after introducing get them ready for shipment just depends on the
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Chapter 18 Additional Aspects of Product Costing Systems 569

number of cartons. All items have about the same commercial freight. The remaining 5,000 cartons
inventory turnover so space and handling costs are were shipped under the desktop delivery option.
proportional to the number of cartons that go Midwest made 2,000 desktop deliveries during the
through the facility. year (the average desktop delivery was for 2.5
We use commercial freight for normal ship- cartons).
ments, and the cost is based more on volume
than on anything else. Each carton we ship by • People felt that handling, processing and shipping
commercial carrier costs about the same, 80,000 cartons per year was about the capacity
regardless of the weight or distance. Of course, that could be handled with existing resources of
any carton that we deliver ourselves, through our people and space.
new desktop delivery service, avoids the • The total compensation for truck drivers was
commercial shipping charges but does use our $250,000 per year. Each driver worked about
trucks and drivers. 1,500 hours per year doing the desktop delivery
The team talked with one of the truck drivers doing service. This was also the maximum time available
desktop deliveries: from each truck, after subtracting maintenance and
repair time.
An average delivery time takes about three • Midwest employed 16 order-entry operators. The
hours. But delivery times can be as short as 30 $840,000 of order-entry costs in Midwest’s income
minutes for nearby customers, and up to eight statement included the salaries, fringe benefits,
hours for delivery to a distant customer. We also
supervision, occupancy and equipment costs for
spend different times once we arrive at a cus-
the operators.
tomer’s site. Some customers have only a single
dropoff point while others require us to deliver • With vacations and holidays, each operator
individual cartons to different locations at their worked about 1,750 hours per year. But allowing
site. for breaks, training, and other time off, the
order-entry supervisor believed that operators
Melissa and Tim next checked on the expenses of provided about 1,500 hours per year of
entering and validating customer order data at the dis- productive work.
tribution center. The order entry expenses included the
• Operators required about 9 minutes (0.15 hours) to
data processing system, the data entry operators, and
enter the basic information on a manual customer
supervisors. They spoke with Hazel Nutley, a data
order. Beyond this basic setup time for a manual
entry operator at Midwest for 17 years.
order, operators took an additional 4.5 minutes
All I do is key in the orders, line by line by line. (0.075 hours) to enter each line item on the order.
I start by entering the customer ID and validating The operators spent an average of 6 minutes (0.10
our customer information. Beyond that, the only hours) to verify the information on an electronic
thing that really matters is how many order lines order.
I have to enter. Each line item on the order has to • Some customers paid their invoices within 30
be entered separately. Of course, any order that days, while others took 90 to 120 days to pay.
comes in through the EDI system or internet page
Midwest had recently taken out a working
sets up automatically without any intervention
from me. I just do a quick check to make sure the
capital loan to help finance its growing accounts
customer hasn’t made an obvious error, and that receivables balance. The current interest rate on
everything looks correct. This validity check this loan was 1% per month on the average loan
takes about the same time for all electronic balance.
orders; it doesn’t depend on the number of
items ordered.
Understanding Order Costs
Melissa and Tim collected information from company and Profitability
data bases and learned the following:
• The distribution centers processed 80,000 cartons Melissa looked through recent orders and found five
in 2003. Of these, 75,000 cartons were shipped by that seemed representative of those received during the
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EXHIBIT 2 Midwest Office Products: Five Orders

Order 1 2 3 4 5
Price $610 $634 $6,100 $6,340 $6,100
Acquisition cost 500 500 5,000 5,000 5,000
No. cartons in order 1 1 10 10 10
No. cartons shipped commercially 1 0 10 0 10
Desktop delivery time (hours) — 4 — 4 —
Manual order no yes no yes yes
No. line items in order 1 1 10 10 10
Electronic order yes no yes no no
Payment period (months) 1 4 1 4 4
Source: casewriter

past year (see Exhibit 2). The orders all involved car- these orders had been priced in the standard way for
tons containing merchandise costing about $500 to ac- cost recovery and profit margins, Melissa wondered
quire from manufacturers to which the normal 22% what profits Midwest Office Products had really
markup had been realized. Orders requiring direct de- earned on each of these orders.
livery had an additional 4.5% surcharge. While each of