SF is a division of Sell.com, an internet retailer. SF operates two large server farms, each of which is a set of interconnected computers and hard drives that are used to process sales orders from customers. SF started out with one farm, then added a second farm as the volume of orders rose, and will eventually need to add additional farms over time. SF charges different divisions within the firm for processing sales orders for those divisions. The transfer price is the average actual cost of processing an order plus 10%. Actual costs are a mix of “fixed” costs of $10 million per server farm per year (which include depreciation, utilities, staff, etc.), and “variable” costs of about $0.05 per sales order (which relate mostly to the wages for staff involved in manually correcting about 1% of orders that have problems). The two server farms have a combined capacity to process about 20 million orders, but they are currently running at about 75% of that capacity. All divisions in Sell.com are evaluated based on their operating profits before taxes and capital charges.
(a) Some of the divisions have begun to complain about the high order processing costs charged by SF, and refer to quotes received from outside vendors to process orders that are much lower. They suspect that part of the problem is that SF has no incentive to control its own costs, since it gets back whatever it spends plus 10%. They have threatened to “go outside” but top management has customer privacy concerns and would prefer to process orders internally, unless the gap between inside and outside costs is too much to ignore. What suggestions do you have for top management in terms of their policy for how much SF should charge other divisions for processing sales orders?
(b) What is the current average cost of processing an order?
(c) A more careful evaluation of the costs incurred by SF suggests that orders are in fact generated by three different customer types: a) domestic retail customers, b) overseas retail customers, and c) corporate customers. Each customer type generates about 5 million orders currently. All of the variable costs are generated by overseas retail customers, unfamiliar with some of the data fields they have to fill in when ordering goods, and about 25% of the fixed costs (relating to specialist staff costs) are created by corporate customers who need special attention. These costs are essentially fixed since they require specialists to be available 24x7, regardless of the number of corporate customer orders processed. The remaining fixed costs are common and relate equally to all 3 products. Calculate the actual cost of processing an order for each of the three customer types. Based on the new cost structure revealed, speculate on some of the changes that downstream divisions (those buying services from SF) might undertake to benefit from the results of your analysis.
(d) While the analysis conducted in part (c) mollified some of the divisions buying services from SF (since the outside quotes they had received related to domestic retail customers), they were still uncomfortable about having to pay for excess capacity. The remaining 75% of total fixed costs were spread over the actual orders processed. More important, they felt that the cost of processing an order declined as excess capacity declined, and then would rise sharply as a new server farm comes on line. What suggestions do you have for ways to deal with this concern?
The question belongs to Finance and it discusses about an online retailer with a subsidiary that charges more for processing orders. The average cost of processing the order and other alternatives for this issue have been discussed in the solution.
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