Previous System
Kanthal’s previous costing system was inefficient in allocating resource costs to products and customers in the proportions they were being consumed. The indirect costs were either manufacturing costs that were allocated to products based on direct labour, or S&A costs which were treated as period expenses and allocated to a particular order on a fixed percentage of total revenues basis. Other costs such as materials, wages, and variable and fixed processing were also allocated based on a fixed percentage of sales. It was clear that the old system did not have the sophistication to measure the profitability of individual customers or the real cost of an order. Thus more emphasis was placed on volume of sales rather than on order profitability. As a result, all products for which the price was higher than the sum of all costs appeared profitable.
Furthermore, since the S&A expenses were left unanalyzed and most costs were based on percentage of sales allocations, the real cost of an order for a given customer was not properly captured. These methods of cost treatment lead to the merging of costs and revenues across all orders and sales, despite their profitability or unpredictability. Appendix 'A’ shows that under the old system, two products- one stocked (customer #33514 – case exhibit 7) and another non-stocked (customer #33528 – case exhibit 7) - appeared to be equally profitable at 7.5% profit margin. Under the new system, it becomes clear that customer #33514 is actually much more profitable and that overall profitability is being driven down by customer #33528. Further analysis of these two orders reveals the significant hidden costs and profits. As illustrated in Appendix ‘A’, orders that required non-stock inventory lead to higher overall costs which often made an order unprofitable. Under the old system these additional costs associated with non-stocked inventory, were being diluted in ‘total’ reported figures.
For Kanthal to achieve its new strategy of higher growth and profitability without having to acquire additional S&A resources, changes to the current system were necessary. The management team required a system that would enable them to not only identify profitable versus unprofitable orders, but to also enable them to prioritize and allocate the company’s scare resources based on customer profitability.
Kanthal 90 Account Management System
In an attempt to achieve the company’s new strategy, Mr. Ridderstrale hired a Swedish management advisory group to help his team develop a system to analyze production and S&A costs associated with each order. Over a period of several months of interviews and investigation, the team was able to divide Kanthal’s costs into order and volume costs. Further analysis revealed four major cost drivers associated with order placement and completion:
- Manufacturing order costs – includes the cost of setup and other activities when ordered products are not in stock. This cost is calculated separately for each product.
- Manufacturing volume costs –includes raw materials, direct labour, variable overhead, and the cost of production orders to replenish inventory.
- Sales order costs –includes S&A costs traced to a specific order.
- Sales volume costs – includes all other S&A costs and is allocated proportionately to manufacturing volume costs.
The new system followed the following four step procedure to more accurately calculate the operating profit for an order:
Step-1: Calculate selling and administrative order costs.
This was achieved by dividing the total S&A costs by total number of orders executed, including both stocked and non-stocked orders.
Step-2: Calculate manufacturing order costs for non-stocked products.
This was achieved by dividing the total manufacturing costs (for non-stock products) by the number of non-stocked orders. This step eliminated the disproportionate allocation of manufacturing costs to stocked products.
Step-3: Calculate allocation factor for S&A volume costs.
This was achieved by first computing the ‘total volume costs’ by subtracting the S&A and manufacturing order costs from ‘total manufacturing and S&A costs’. Then S&A volume related costs were divided by manufacturing volume COGS to drive at the ‘S&A allocation factor’.
Step-4: Calculate operating profits on individual orders for non-stocked products.
This was achieved by subtracting the volume related costs (both manufacturing and S&A) from the sales revenues followed by subtracting manufacturing and S&A order costs to obtain the operating profit per order.
This new system enables the management team to analyze order profitability by customer, by product group or by all orders received by a customer in a country. The reports from this system would, for example, show a customer’s bottom line profits broken up by invoice value, volume and order costs, and additional non-stock cost (if applicable) would be traced back to the customer. Now managers are able to see the variability in profits from customer to customer. For example, profit margins for individual orders varied from -179% to +65%, where previously almost all of these orders would have appeared profitable. The most attractive feature of the new system is its ability to capture the cost associated with non-stock orders. For example, country customer # S005 (from case exhibit 6) shows a profit margin of -42%. Further analysis reveals that this specific order incurred additional stock-out costs since ‘finished wire’ was out of stock. The cost of non-stocked ‘finished wire’ is SEK2,340 and the profit loss on this order was –SEK1,319. If, at the time of the order, ‘finished wire’ was in stock, this customer order would have been profitable. With this information, the team can better prioritize the orders as they come in. They will have the necessary information to decide whether an order should be placed immediately or if it should be delayed until specific inventory parts have been replenished.
Limitations of Kanthal 90 Account Management System
Although the new system is more efficient in proportionately allocating the S&A expenses to various products and customers, it has some inherent limitations. For one, it requires a lot of effort and resources to track each and every customer order. The old system’s simplicity is probably the primary reason why the organization did not move to a much more sophisticated accounting system. Furthermore, it will take time to convince the sales force to change their current behaviour. The new system’s benefits will only be realized if the employees are using the outputs and making sound decisions based on the results. Currently the sales force’s primary focus is on top line growth, however, with the new system, they are realizing that some of their top customers (in sales) may not necessarily be the most profitable. As a matter of fact, two of the most unprofitable customers account for the largest sales volume orders per customer.
Therefore, a change in employee and sale force behaviour is necessary for a successful implementation of the Kanthal 90 system. The top management teams must be prepared for initial resistance to the new system and necessary steps, such as training and educating the employees, will be required to mitigate the level of resistance.
Impact of Non-Stocked and Small Orders
As previously discussed, an order for a non-stock product often leads to unexpected losses. Appendix ‘B’ provides an example for two orders of SEK2,000, but one is for a stocked item and the other is for a non-stocked item. It is important to note that the order for a non-stock profit leads to a negative profit margin of -100%, whereas the order for the stocked product is actually profitable at 13%. The extra cost of a non-stock order is so significant at SEK2,250 that it makes an order size of SEK2,000 unprofitable. Appendix ‘C’ provides an example for a larger order size of SEK160,000 for two different customers. Customer A’s sales are from three large orders of non-stock items and customer B’s sales are from 28 small orders of which 6 were for stocked and 22 for non-stocked items. Even though customer A’s orders were for non-stocked items, it had a higher profit margin than customer B who had more orders placed for stocked items. This illustrates the value of large orders versus small ones. Because each time an order is taken the company incurs handling costs, it becomes extremely important to focus on large items or to consolidate orders into one large one versus many smaller ones.
There are two very important lessons that can be learned from Appendices ‘B’ and ‘C’. The first lesson is that non-stock orders create additional costs that should be avoided if possible. Second, if the monetary value of orders is the same, customers that place a lower quantity of orders will be more profitable than customers that place many orders. Necessary steps and guidelines must be established for the employees to follow in order to effectively handle cases such as these.
How to Handle Unprofitable Customers
Currently Kanthal is faced with two unprofitable customers with large sales volume. There is an opportunity for Kanthal to turn these unprofitable customers into profitable customers. Further investigation reveals that one of these customers is using Kanthal as a backup supplier for last minute orders. Analysis indicates that orders of this type lead to unnecessary non-stock costs for Kanthal. In this case, Kanthal should consider implementing a surcharge for orders that require an immediate turnaround. This surcharge should be set so that it is sufficient to compensate for the additional costs incurred by rush orders. Furthermore, Kanthal should consider offering this customer some incentive so that they become a primary supplier. This will not only eliminate last minute orders, it will also reduce the number of non-stock orders. Kanthal should also offer their customers discounts for placing large orders. Given the significant charge associated with each order, it becomes very important to ensure that customers are placing fewer orders of larger values. Finally, if all efforts fail, Kanthal should focus its efforts on increasing sales volume for profitable customers and stop doing business with the unprofitable ones.
Appendix ‘A’ – Diluted Profits
Appendix ‘B’ – Impact of Non-Stocked Orders
Appendix ‘C’ – Impact of Small Orders