Accounting Case Analysis: Electronic Commerce Network (A) & (B)

158-C01A 4/20/01

Professor William Lawler, Babson College, prepared this case as a basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.

Copyright © by William Lawler 2001 and licensed for publication at Babson College to the Babson College Case Development Center. To order copies or request permission to reproduce materials, call (781) 239-6181 or write Case Development Center, Olin Hall, Babson College, Wellesley, MA 02457. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means – electronic, mechanical, photocopying, recording, or otherwise – without the permission of copyright holders.

Electronic Commerce Network (A) It had been eighteen months since Dave Roger, an experienced e-commerce consultant,

had started Electronic Commerce Network (ECN.W) to offer transaction processing capabilities to web merchants. While he had experienced no difficulty in obtaining initial funding, the next round of financing was proving to be much more challenging, even though he now had a proven business with ten satisfied merchants and their fulfillment partners loaded onto his network. The growth potential was strong. Potential investors, however, were asking detailed questions about ECN.W’s business model:

If you were a manufacturer we would expect you to tell us how you will use our investment - some goes to infrastructure such as plant and equipment and some to working capital such as inventory and receivables. You would then tell us how much it would cost you to build your product, how much to market it, how much to service it, and what customers would be willing to pay for it. Our first round of investment would have given you sufficient experience to gather this type of data. With this information, you could explain your business model - how you would create enough wealth to pay back our principal plus our required return. Now, since you are a service provider rather than a manufacturer, can you explain your business model in like terms? What infrastructure is necessary for your business? What does it cost you to provide your service? How much does it cost to market these services? What are customers willing to pay for it?

Unable to answer, Dave decided to hire Denise Pizzi to help out with this project. She had come highly recommended and understood how to develop the required activity analysis. She quickly pulled together a cross-functional team of ECN.W personnel, and within a month, it identified three high-level processes that best defined ECN.W. -- Customer Capture, Customer Loading and Transaction Processing.

Dave had just received the preliminary team report, and was assessing what it meant for the company and how prospective investors might react.

ECN.W (A) 158-C01A

Electronic Commerce Network When the company was first conceived, Dave had known from his consulting practice

that transaction processing caused the most problems for web merchants. Web customers expected instantaneous service and, while each web sale appeared to be relatively simple, the process actually involved coordinating some 12 underlying transactions (see Figure 1). Both credit-worthiness and product availability had to be ascertained before a sale could be consummated. If both were satisfactory, the transaction would then be completed. Then logistics and accompanying tracking transactions had to kick in. In addition, the customer’s buying profile on the web merchant's database had to be updated. These all had to be done seamlessly and on a real-time basis.

Most web merchants built or bought integrated software platforms for transaction processing. Companies such as Cybersource provided credit confirmation software systems, Yantra fulfillment and inventory management systems, and Oracle database management systems. Interfaces had to be built to allow these systems to "talk" to one another. Since each of these software systems was regularly upgraded, the maintenance of these interfaces could be a nightmare. To make matters worse for the web merchants, experienced IT personnel in this area were scarce and headhunters for large companies were quick to hire away anyone with the prerequisite experience. As a result, web merchants found that they spent more time then they cared to on transaction processing issues.

Dave Roger had therefore crafted a business model based upon a hosted network concept. He described the ECN.W customer value proposition to web-merchants as follows:

You, as a web-merchant, should spend the majority of your time on your primary mission of creating value through innovative marketing and sales offerings to customers and clients1. You should avoid spending both scarce managerial talent and investor capital on any activity that could best be performed by third-party partners such as ECN.W. Do investors see the value in your building transaction- processing systems with their investment dollars that are sub-optimal in scale and soon obsolete, in hiring and training high-cost personnel to run these inefficient systems, or in spending much of your creative energy trying to manage these inefficient systems? The answer is clearly “NO.”

Join our network and get all these services seamlessly provided with state-of-the- art applications run by highly trained IT professionals (see Exhibit 2). We will convert a difficult-to-manage fixed infrastructure cost into one that is totally scaleable and variable since you pay only on a per-transaction basis. With us as your partner, you can direct your creative energies where your investors expect.

Denise Pizzi’s team had studied customer capture and customer loading processes in detail and reported the following:

1 Clients were also called fulfillers. An apt analogy is the role Wal-Mart, a brick and mortar rather than web merchant, plays for its suppliers (or fulfillers in the e-commerce world) such as a Procter & Gamble.

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1. Customer Capture involved all the activities that culminated in a signed contract. These activities were identified as:

o Customer Identification -- This involved sub-activities of trade-show

attendance, trade show preparation and advertising. By tracing travel itineraries and such, it was established that ECN.W had spent approximately $875,000 on these activities in the past 12 months.2 This resulted in 1,200 customer leads.

o Customer Qualification – This involved basic research to identify the sub-set of high-potential prospects with enough size and credit worthiness to pursue. ECN.W had out-sourced this activity to a credit agency, paying approximately $175 per credit report. 80 such high-potential prospective customers were identified from the 1,200 leads.

o Customer Sale – This involved making telephone calls and site visits to high- potential prospects in order to close the sale. ECN.W had successfully closed on 10 of the 80.3 The other 70 did not sign contracts either by their own choice or ECN.W's. Appendix A has additional data for this activity.

2. Customer Loading involved all the activities necessary to enter the web merchant and its

fulfillers onto the ECN.W network. Over the past 12 months the equivalent of 7 customers went through this whole process. The relevant activities were identified as:

o Business Operations Review -- ECN.W spent about $3,600 on each of the 7

reports that were outsourced to a number of subcontractors who documented the operational flow of the web merchant.

o System Design -- ECN.W technical staff wrote of all of the software interfaces and configuration of hardware linkages for transaction processing, costing about $5,000 for each of the 7 systems.

o Implementation & Certification -- ECN.W staff installed and tested each to ensure that it was working as designed. Although there was minimal variation in the effort for the first two activities, this one varied greatly depending upon a number of factors (see Appendix B).

APPENDIX A

Customer Sale Analysis Detail The total cost for this activity pool came from across the company. When a high-

potential prospect expressed continued interest in the initial phone call, site visits were 2 Initially, these activities were analyzed separately but since they were not mutually exclusive (i.e., advertising resulted in trade show booth visits and trade show exposure made advertising more effective, they were then aggregated. 3 Since all of the activity did not fall neatly into the twelve-month analysis window, these numbers are expressed in full-time equivalents. Although some of the sales activity had begun prior to the start of the past 12 months and some would continue on into the following months, it was estimated that ECN.W pursued the equivalent of 80 and closed 10 in this time period.

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organized. This meant flying out sales people and technicians to demonstrate how the system worked. Top management of the larger companies usually expected to meet with ECN.W top management to assess the professional caliber of the company to which they were considering entrusting a crucial part of their business. Pizzi’s team found that this activity was extremely variable -- there was no "typical" account. Generally, prospects fell into two categories depending on whether or not they understood the customer value proposition and the inherent costs. The process was as follows for the first category:

o A sales person and a technician spent approximately three days visiting the prospect’s site -- one for travel, one to understand current transaction processing systems, and one to demonstrate the advantages of ECN.W’s hosted network approach.

o A sales person then spent an average of two days revisiting the prospect to "close" the deal -- one for travel and one for negotiation.

o After the sales person thoroughly briefed Dave Roger about the prospect, he would often call the customer to talk "CEO to CEO" sometime in between these two trips. This took about a half-day of effort from both the sales person and Dave Roger.

For those often-skeptical prospects that did not understand the customer value

proposition and the inherent costs, the sales process was more complicated. Unfortunately, 7 of the original 10 fell into this group.

o The sales person would first spend an average of two days visiting the prospect to introduce ECN.W and explain the customer value proposition in detail -- one day for travel and one for meeting the customer and demonstrating the product.

o A sales person and a technician would then spend approximately five days revisiting the site -- one day for travel, three to educate the client on how transaction processing was currently being done internally and its costs, and one to demonstrate the advantages of the hosted network approach.

o The sales person would then spend an average of two days with the prospect to "close" the deal – one day for travel and one for negotiation.

o Finally, Dave Roger would spend about two days visiting the new customer to demonstrate ECN.W's commitment to customer satisfaction -- one for travel and one for discussion

APPENDIX B

Implementation & Certification Analysis Detail Like the other activities, costs for this activity pool came from across the company and,

like the Customer Sale activity, had a high degree of variability. In general, customers fell into two broad groups: those that had competent IT staffs, were prepared for and responsive to ECN.W's implementation team, and had only one fulfiller; and those that were neither competent nor responsive and had many fulfillers -- four, on average.

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For the former group, the installation and test procedure required a team of two technicians, one at the customer site and the other at the fulfiller, each for only two days -- one for travel and one for implementation. Most of the work was performed by client and fulfiller IT personnel. Final certification was done at ECN.W and required only one additional day for minor debugging.

For the latter group, however, the process was much more difficult. Typically, it required a team of three technicians and two trips to the customer site -- an initial three-day visit by two technicians and a second two-day trip by a single technician for major revisions due to unforeseeable problems. Likewise, dealing with multiple fulfillers that were less than prepared meant more and longer site visits for the third technician, usually three days in duration for each fulfiller -- one for travel and two for on-site work. Certifying the system also took twice as long at ECN.W.

Assignment: The group gathered the following data from the general ledger (see Exhibit 3), travel

expense reports and other varied sources:

o Number of sales people at ECN.W – 2 @ 250 days/yr = 500 days/yr o Number of marketing people at ECN.W – 2 @ 250 days/yr = 500 days/yr o Number of technicians at ECN.W – 9 @ 250 days/yr = 2,250 days/yr o Training & Development expense detail - $25,000 for sales and rest for

technicians o Payroll benefits -- averaged 20% of salaries for all functions o Average round-trip airfare and related transportation costs per person, $2,000 o Typically a three-day trip meant three nights in a hotel; two days, two nights; and

so on at an average cost of $500 per day per person.4

A) Prepare an activity cost estimate for Customer Sale and Implementation & Certification. B) Prepare a cost estimate for Customer Capture and Customer Loading processes in total.

Assume a 250-day work-year for all salaries.

Be prepared to discuss your logic:

1. Regarding the proper definition of the object you are trying to cost, 2. Whether the cost pools for the activities you are costing are predominately fixed or

variable and how this effects your answer, and

3. Assuming that the group found that the costs associated with the 70 high potential customers that withdrew from the sales process before signing a contract totaled $232,000, how would you treat this cost?

4 This included all meals, room costs and any miscellaneous expenses.

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Exhibit 1 E-Commerce Transaction Detail

R e a l

-

T

i m e

Web

Merchant Customer

Transactions #1 #2 #3 #4 #5 #6 #7 #8 #9 #10 #11 #12

Credit check

In stock check

Ship if #1 & #2 “Yes”

Track

Charge customer

Update customer profile Transaction summary to customer

credit company

fulfiller

fulfiller

common carrier

credit company

Exhibit 2 ECN.W Value System

Web- Merchant

Customer ECN.W

Visa,AmExp MasterCard

Fulfiller

FedEx, UPS

Transaction flow

Physical flow

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Exhibit 3 General Ledger Accounts with Adjustments

Past 12 months

As Reported Fully LoadedDay/Year Rate/Day Sales Salaries 250,000$ 50,000$ 25,000$ 325,000$ 500 650$ Marketing Salaries 200,000$ 40,000$ 240,000$ 500 480$ Technical Salaries 900,000$ 180,000$ 157,500$ 1,237,500$ 2,250 550$ Administrative Salaries 200,000$ 40,000$ 240,000$ CEO Salary 750,000$ 150,000$ 900,000$ 250 3,600$ Payroll Benefits 460,000$ -460,000 $ -$ Training & Development 182,500$ -182,500 $ -$ Travel Expenses 340,000$ 340,000$ Meals and Lodging 387,000$ 387,000$ Consultants 287,000$ 287,000$ Advertising 350,000$ 350,000$ Other Marketing Expenses 180,000$ 180,000$

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