Dakota Office Products' profitability crisis and operational restructuring

¶ … growing sales, Dakota Office Products saw its profit margin evaporate in fiscal 2000 as expenses became untenable. Anxious to restore profitability, Dakota Office Products (Dakota) turned to our firm in order to determine the culprit behind these runaway expenses. In order to do so, we looked to the financial statements provided to us by John Malone, General Manager at Dakota and spoke with Dakota's Controller, Melissa Dunhill, and Director of Operations Tim Cunningham.

Our findings revealed that Dakota had made several structural changes to business operations, as was revealed in an audit of Dakota's distribution center conducted by Mrs. Dunhill and Mr. Cunningham. A report written subsequent to the conduction of this audit demonstrated to us how expenses had been materially affected by several changes implemented by upper management, which included:

The Introduction of Desktop Delivery

The Introduction of an Online System for the Processing of Orders (Electronic Data Interchange.)

As both of these systems have had a substantive impact on expenses, we will review each of them and develop a new profit statement which breaks Dakota's business into several operating units, consisting of ones that have been effected by recent changes and ones that haven't. In this review, we will show that Desktop Delivery has augmented expenses to an extent that has cost Dakota its profitability, and discuss alternate scenarios where Desktop Delivery is priced in accordance with the expenses that it generates, and where it is eliminated altogether. We will then review the extent to which Electronic Data Interchange (EDI) has ameliorated the effect of Desktop Delivery on earnings. In addition, we will discuss the matter of multiple orders and their effect on profitability. We will conclude by introducing a pricing system that will hopefully cause profitability to return to pre-2000 levels.

Electronic Data Interchange

We have found the implementation of Electronic Data Interchange (EDI) to have had a positive overall effect on performance. In the past, the company has chosen to adopt a pricing system that reflects the cost of goods plus a premium reflecting variable costs and profit. EDI has enhanced profits because it allows Dakota to provide the same service at an arguably greater level of convenience while experiencing lower labor costs. Of the total amount of time spent by data entry clerks entering orders in 2000, only 5% of this time was spent on electronic orders, while the rest was spent on manual orders despite the electronic orders representing 1/3 of the total number of orders received by Dakota. If such orders could be increased to 1/2 of the total number of orders received by Dakota, this alone would result in a savings of 21.25% in labor costs associated with Data Entry Operators. Theoretically, if all orders were completed electronically, such expenses could be reduced by 85%. Because the nature of the Data Operating function would be significantly scaled back, this operation could be outsourced to a smaller firm specializing in data entry.

Dakota could build revenues by taking actions to encourage EDI purchases, which would exploit these cost disparities. One option would be to initiate a promotion that would put people in the habit of ordering things online. It can be assumed that once adopt EDI as a method of submitting purchases, that they will be more likely to do this in the future rather than relying on traditional purchase methods. Because such a rebate would be non-recurring, these customers will continue to use the automatic system without a discount and allow Dakota to profit from the new system's economies by reducing the size of its staff. Another option would be to get the delivery staff responsible for the Desktop Delivery process to prompt customers to ask them questions about the new system in order to pique interest. This will benefit the company with the market segment that is slow to adopt a new technology and must rely on personal guidance in order to familiarize itself with a new system. Our group feels that if this system had not been implemented, losses experienced in 2000 would have been much worse.

Multiple and Consolidated Orders

It has been demonstrated that Dakota experiences greater expenses when handling a large number of small orders than it does when handling a small number of large orders. However, this competency is not reflected in the way that clients are billed. To change the billing structure to reflect this feature of order placement would serve several immediate goals.

It would more aptly reflect Dakota's billing methodology.

It would allow for more transparency in the company's financial statements.

It would provide incentive for customers to utilize EDI.

Dakota's billing methodology is one that could be called 'value-added.' The price of a product is based on the cost to Dakota, plus a premium that reflects fixed and variable expenses. Most of these expenses can be classified as variable. We were presented with the example of a company A and a company B, where A exemplified a 'good' company in that its sales contributed to revenues and B. exemplified a 'bad' company, whose business contributed to expenses. Although a review of their respective accounts leads to an intuitive understanding of their respective merits, these merits would be immediately transparent if operating expenses were to be calculated on an account-by-account basis where sales were matched with the expenses that they generated. This is the system recommended according to GAAP.

When a large number of small orders arrive rather than a small number of large ones, the negative effect is duo-fold. The first effect it has is on the time spent entering the order. If the first type of order is submitted, the number of individual order lines increases, along with the number of manual customer orders increases. Such customer orders accounted for 2,000 out of 10 thousand hours of labor spent in fiscal 2000. The second effect is on the number of deliveries made, which increases if customers take advantage of the Desktop Delivery service. There were 2000 such deliveries in fiscal 2000. It can be assumed (since Dakota averaged six deliveries a day) that the cost of delivering a small item is identical to the cost of delivering a large item. If it can be assumed that Company A and Company B. constituted the total sales volume, nearly 72% of the time spent by Dakota on processing orders was spent on Company B, along with 100% of desktop deliveries.

Conclusion and Recommendation.

Dakota's billing structure is one that is marred by adverse selection. As evidenced by the recent audit, however, Dakota has shown initiative in addressing the recent problems associated with losses incurred in the year 2000. The final step will be to implement billing changes that reflect a desire for profitability. This will provide incentives for revenue generating customers (such as company A) to do business with Dakota while discouraging customers that only generate expenses. Dakota is in the habit of charging customers for operating expenses in a way that does not reflect the individuated natures of these expenses. As was demonstrated with Desktop Delivery, this causes costs to be inordinately distributed among customers in a way that erodes Dakota's revenues. It can be assumed that this negligence has remained unchanged for at least 17 years, probably owing to the company's continued profitability. However, with these new insights, it is almost certain that Dakota will adopt these new measures and return to profitability.

Figure A: Dakota with and without its Desktop Delivery customers.

With Desktop Delivery Without Desktop Delivery

Sales

Cost of Items Purchased

Warehouse Personnel Expense

Warehousing Expenses

Freight

Delivery Truck Expenses

Order Entry Expenses

General and Selling Expenses

Interest Expense

Total Expenses

Net Income before Taxes

Difference