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Elkay Plumbing Products Division

Overview

• The case focuses on how a manufacturing company measured the cost and
profitability of each of its 6000 products and 2000 customers.
• It asks the students to propose and debate options for improving product and
customer profitability.
• The company has installed a new time-driven activity-based cost system to
measure the profitability of its individual products and customers.
• The new system reveals that the most profitable 1% of products and customers
generate 100% of profits, and that the most profitable 20% of products and
customers generate 225% and 175% of profits respectively.
• The case describes the company’s near-term actions to address the large number
of unprofitable products.
• It closes with the sales manager deliberating about how the company should deal
with its most profitable and unprofitable customers.
Background on Time-Driven Activity-Based Costing
• The case mentions briefly that Elkay had tried activity-based costing ten years earlier and the
project failed.
Problems with traditional ABC
• Employees hated the surveying procedure, estimating the percentages of their time spent on the
list of activities handled to them.
• Hard to estimate percentages of time; much easier to estimate how long each instance of an
activity takes. (Example – what percentage of time a faculty in an academic year is spent in
grading final exams v/s estimating how long it takes them to grade a single exam – once they have
developed the grading scheme.
• Difficult to validate the percentage estimates – would have to observe the employee over several
weeks or months to learn about the accuracy of any estimated percentage.
• People’s estimated percentages invariable summed to 100%; this gave no visibility into unused
capacity and, when substantial unused capacity existed, the estimates cost driver rate would be
much too high, and therefore over-costed products and customers.
Time-driven ABC solved all these problems. It requires only two parameters to build a cost system
• The cost of supplying capacity for each resource.
• Estimated demands on capacity by each cost object (transaction, order, product, shipment,
customer)
Q1. Suppose you are Mark Whittington (VP of Sales). What would you do with
highly unprofitable customers, especially the two large customers, at the extreme
right-hand side of the whale curve, who lose about 40% of the company’s profits
between them?
• If you recommend firing these unprofitable customers, then the revenues would
disappear immediately, but many costs associated with producing for and serving
these customers would not disappear immediately, so short-term profits and cash
flow would decrease.
• Some of the losses with these customers are self-inflicted since Elkay may have
granted high discounts and allowances to these large customers without
realizing how unprofitable they were. So a more prudent action could be to cut
back on special deals until the customers become profitable.
• These two customers could have strategic benefits beyond what is shown in
their P&L’s. The two customers are large improvement retailers and enable
potential consumers to view Elkay’s products before purchasing them, at high
margins, from their builder or home improvement contractor.
• Elkay may have over-featured the products it is selling to these price-sensitive
retailers, and therefore be incurring high manufacturing costs for these products.
• Elkay may have options to negotiate with the retailers to improve profitability,
through a more focused product mix, modified inventory and distribution
policies, and even selective price increases.
Q2. How does a company end up in the situation with large
cumulative losses with unprofitable customers and also a large
number of unprofitable products (see Exhibit 9 on page 18)?
Elkay’s recent history and competitive situation

• It is a mature company that has introduced a new strategy of moving upscale in its
market by emphasizing product design and rapid prototyping of customized low-
volume sinks, while still retaining high-volume production of commodity sinks.
• It also has moved into new price-sensitive sales channels.
• Recently, materials price increases have led to decreased gross margins, and the onset
of the housing industry recession, reinforced by the financial crisis, has led to volume
decreases and even more pricing pressure.
• Elkay now has high product variety (high and low volume, standard and custom, mature
and new) and a proliferation of customers and selling channels.
• Its standard cost system, which allocates overhead costs proportional to the volume of
products produced and sold, will almost surely under-cost low-volume, specialized
products and over-cost high-volume standard products.
• Elkay which has historically been product-focused, and has differentiated itself by
adding complex design and fabrication capabilities and is now designing and producing
new, custom low-volume products with advanced features.
• A volume-based cost system will not attribute all the costs of designs, fabrication, and
finishing to these innovative, complex products (see pictures of these products in case
Exhibit 1).
• In addition, when entering new sales channels, such as the retail outlets and
fabricators, the company’s normal business model may not apply.
• The new customers may be much more price sensitive leading to a breakdown in
the company’s traditional pricing model.
• The new customers, many of whom are much larger than Elkay, may demand
volume-based discounts, and special sales promotion and local advertising
allowances that eat into Elkay’s margins.
• Without accurate data on customer profitability, sales and account managers
may have acceded to requests for additional discounts, allowances, and rebates
that were unrelated to the customer’s profitability.
• This issues gives an opportunity to draw a matrix which shows (in the right-hand
cell) the danger of offering discounts to customers with whom you are earning
only low margins.
Summarize the previous discussion

• Elkay was an excellent candidate for a more accurate (ABC) cost system:
• High diversity of products and customers; 6000 SKUs, 2000 customers
• High indirect and support costs (and sales deductions). The table on page 3 of the
case shows that direct labor is only 5% of total costs, while factory overhead is
25%, distribution and corporate overhead is 33% and sales deductions and
allowances are 11%.
• None of these indirect costs or revenue deductions is assigned accurately by a
volume-based costing system.
Q3. What distinguishes a low cost-to-serve customer from a
high-cost one?
Measuring Customer Profitability
High Cost-to-Serve Customers Low Cost-to-Serve Customers

 Order custom products  Order standard products


 Small order quantities  High order quantities
 Unpredictable order arrivals  Predictable order arrivals
 Customized packaging and delivery  Standard packaging and delivery
 Change delivery requirements  No changes in delivery requirements
 Manual processing  Electronic processing
 Large amounts of pre-sales support (marketing,  Little to no pre-sales support (standard pricing
technical and sales resources) and ordering)
 Large amounts of post-sales support (installation,  No post-sales support
training, warranty, field service)
 Require specialized inventory
 Little inventory support required
 Pay slowly (high accounts receivable)
 Pay on time
 Require high discounts and sales and promoting
allowances  Pay list price; no revenue deductions
Q4. Has any of you experienced a highly unprofitable
customer relationship? How does this arise and why did it
persist? What did your company do with this customer?
Q5. How was the new Discrete Product Costing (DPC) system
an improvement over the previous cost system?
• DPC assigns cost based on actual flow and run and setup times in production
centres; and on process times in distribution centre.
• The DPC starts by mapping all the processes – design and development,
production and finishing, and storage and distribution.
• It drives resources costs to each process (or production department) and
measures the time each order or product uses on each process.
• The times becomes the mechanism by which process costs get assigned down to
products and orders.
• The DPC system assigns freight and delivery costs, and revenue deductions
(trade deals, promotions, rebates, returns, discounts) directly to individual orders
and customers.
• The previous system aggregated all these delivery costs and revenue deductions
into large pools that were allocated arbitrarily (by sales volume) and inaccurately.
Q6. What limitations or concerns do you have with the Elkay
DPC system.
The project team (with Jack Haedicke’s encouragement) did take some shortcuts to get the
system up and running quickly, including the following:
• Elkay’s DPC did not use a central benefit of time-driven ABC, the calculation of capacity
cost rates for each process or department.
• The DPC system captured process times by each product and order, but assigned
activity (process) costs proportional to the percentage of time used by each SKU (see
bottom of page5).
• This procedure gives no visibility into unused capacity and risks over-costing products
when a process has significant unused capacity.
• This is an opportunity for improvement when Version2.0 of the DPC system is
developed.
• To save time during the project development stage, many indirect costs were allocated
by readily-available volume drivers rather than by estimated time consumption.
• Several significant SG&A cost categories, which could vary across orders and customers,
were allocated by volume of sales.
Q7. Most new systems meet strong resistance from line managers
(note comment on page – 4, “We tried this before; it didn’t work”).
The DPC system seemed to get quick acceptance at Elkay. Line
managers (product managers, business unit managers, marketing and
sales managers) were willing to take strong actions based on data
even from initial runs. Why do you think this occurred at Elkay?
• One can find several important factors at work that led to managers taking prompt
action based on the information revealed by Elkay’s DPC system.
• The project had strong support and sponsorship from senior executives.
• CEO, Tim Jahnke and PPD president, Steve Rogers were new to their jobs and therefore
did not have to defend the previous cost system or lack of decision-making in response
to the recent profit declines.
• The company assigned an excellent project team, staffed by experienced and trusted
managers with finance, operational and IT expertise.
• The internal team was well supported by an experienced and expert external consulting
team.
• Jack Haedicke, an outside consultant with 20 years of experience leading and
consulting on ABC projects, served in parallel with the internal project leader,
influencing many key design decisions and driving the project forward to get the first set
of results quickly.
• The project team piloted DPC in just two sites – one production centre and one
distribution centre – so it could quickly get to results that it could share with line
managers.
• Haedicke insisted on a senior level steering committee, the “Expanded Team”, consisting
of key executives and decision-makers, that met throughout the project to approve
major design decisions and gain confidence in the validity of the DPC system.
Q8. How did the information on product and customer
information help PPD’s managers?
• Improve internal processes; e.g., eliminate costly trans-shipments across the
company by adding a new production line in the Utah plant to service West Coast
outlets, reduce change-over times.
• Re-design and re-engineer products; e.g., take out features such as expensive
finish, tight corners, and vertical walls that customers do not value or are not
willing to pay for. Some customers just wanted a sink that holds water and drains.
• Price based on features and services desired by customers (menu-based
pricing): e.g., offer low prices for standard sink sold in high volumes, add price
premiums for a low-volume, customized sink with special features, or for special
delivery options.
• Modify relationship: share the data with the customer, “Would you do business if
this were your customer?” The account representative works with the customer
to reduce costs such as by reducing the number of low-volume SKUs, agree on a
minimum order and shipment sizes, deliver in full rather than less-than-truckload
shipments, link discounts, trade allowances and rebates to profitable orders, not
just the size of the order.
Q9. What should Whittington do with the highly profitable
customers on the extreme left-hand side of the whale curve?
• Recall that one of these customers had previously asked Elkay to produce a
private-label sink.
• Elkay, not wanting to cannibalize its branded products with a lower-priced
alternative, refused and suggested that the customer ask a Chinese producer to
produce the private-label sink.
• Elkay now realized that the last thing it wanted for its most profitable customer
to start buying sinks in China.
• Elkay returned to the customer indicating that it would be delighted to work
with it to design and produce such a private-label sink.
• For its most profitable customers, Elkay assigned a full time account
representative to understand the customers future needs and work
cooperatively to develop customized solutions for them.
• This included co-creating new designs and introducing a customer loyalty
program.
Q10. How should Whittington manage the two large unprofitable
customers on the extreme RHS of the whale curve?
• ABC studies for the past 20 years have found that large customers are either a
company’s most profitable or its most unprofitable customers; “you can’t lose a
large amount of money with a small customer”.
• Elkay was selling a “$300 sink” to a large home-improvement retailer that was
being sold to consumers for $100, the desired price-point for the consumers who
purchased at the discount retailer.
• Elkay, as it conducted frank and candid discussions with its large unprofitable
customers, again learned that it had over-featured the sinks sold to these
customers’ end-use consumers.
• It went back and simplified the design, which enabled production costs to
decline substantially.
• Also, it worked with the customers to reduce product-line breadth, which
lowered production, inventory and distribution costs.
• One of these unprofitable customers was the one it was shipping sinks from the
North Carolina plant to the retailers West Coast distribution centres.
• Elkay learned that it was cheaper to build another die so that the sinks could be
produced in the Utah plant and have much lower distribution costs to the US
west Coast.
• Fortunately, the two most unprofitable customers knew that Elkay was one of
their most profitable suppliers.
• This enabled Elkay to negotiate a significant price increase from them even in
the midst of the deep US housing and economic recession.
• One of these customers went from the 2nd most unprofitable to the 5th
profitable within six months as a result of the constellation of actions taken with
it.
• It is generally much easier to transform an unprofitable large customer into a
profitable one than to replace the lost sales by acquiring a whole set of new and
smaller customers.
• Next Session on Cost Behavior and Cost-Volume-Profit (CVP) analysis