Danshui Plant No. 2

In August 2010, Wentao Chen, manager of Danshui Plant No. 2 in southern China, was anxious.

The plant was in the third month of a 12-month contract to assemble the Apple iPhone 4. The contract

called for Danshui to assemble 2.4 million iPhones in the period between June 1, 2010, and May 31,

2011, but now in the third month of the contract, production was only 180,000 units per month. Chen

called Jianye Ma, the plant controller, to request a summary of monthly operations for August as

soon after the end of the month as possible.

Danshui was a contract manufacturer that assembled electronic products for companies wishing

to save labor costs by locating in southern China where semiskilled labor was available for less than

one dollar an hour. Manufacturers like Danshui assembled parts in large plants using assembly line

techniques according to specifications of the international companies that contracted with them for

assembly and final testing. The largest contract manufacturer in China was Foxconn, a division of the

Hon Hai Group of Taiwan, with more than 800,000 workers in China alone and contracts to supply

Apple, Dell, and Hewlett Packard among others.

In expectation of high demand for the iPhone 4, Apple had contracted with Danshui to assemble

iPhones in Plant No. 2, which had been assembling computer hard drives on a contract that was

fulfilled at the end of May 2010. Although the assembly of hard drives was different than assembly of

iPhones, Danshui was confident that its workers would adapt to the new assembly tasks and that it

could hire and train the additional workers as needed. Chen's job was to get Plant No. 2 up to speed

to fulfill the Apple contract and earn a profit for Danshui's parent company, located in Hong Kong,

China.

Danshui Plant No. 2 was a profit center that was credited for each iPhone produced and shipped,

and charged for parts, labor, overhead, and shipping. Because the contract was for a year, an annual

budget was established soon after the iPhone contract was signed. This budget was divided by 12 to

establish equal monthly budgets to which actual revenues and expenses could be compared. All

budgeting and monthly reporting was done in U.S. dollars.

As the plant manager, Wentao Chen was responsible for control of all costs in his plant. Materials,

labor, and overhead were his responsibility. This was done to provide incentive to control all costs

whether caused by use waste, damage, theft, or inefficiencies.

The Apple iPhone 4

The iPhone 4 contained more than 100 components manufactured in plants located in Europe,

Asia, and the United States. For examples, Samsung supplied flash memories and application

processors, and Infineon (a German chip maker) supplied chips that send and receive phone calls and

data. A gyroscope, new to the iPhone 4, came from STMicroelectronics, based in Geneva, and a

touch-screen module came from Taiwan. Contract manufacturers assembled these parts in assembly

line plants that required each worker to focus on one or more tasks in a short period of time as each

phone moved along an assembly line toward completion. Estimates of the material cost of each

iPhone were around $180, assembly labor around 7% of total cost, and Apple's profit margins about

60% of the selling price to customers. (See Exhibits 1 and 2 for estimated standard costs and

overhead budgets for the Danshui Plant No. 2.)

The assembly process at Danshui Plant No. 2 was almost entirely based on handwork by workers.

There were about 140 steps in the assembly process for an iPhone 4, and each phone was handled by

325 individuals during the five days required for assembly. Apple released the iPhone 4 on June 24,

2010 and more than 1.7 million units were sold in the first three days it was available. It was the

most successful product launch in Apple history. Apple fanatics around the world waited in long

lines to get their hands on the new phone.

The August Report

On September 2, Chen arrived at his office and found a report on August operations. (See Exhibit

3). The controller, Jianye Ma, had attached a note which Chen read with interest.

To: Wentao Chen

From: Jianye Ma and Bingqian Li

Date: September 1, 2010

Per your request we have compiled a preliminary report on August operations. At

first glance, revenue was below budget, material usage seems good, and labor costs were

above budget. In terms of plant profit, our budget was $100,000, but we actually had a

loss of $672,000. The main reason for the shortfall may be that we have been unable to

produce 200,000 iPhone 4 units in any of the three months we have been working on this

contract.

Our major obstacle is hiring enough qualified labor to get production up to 200,000

units per month. We cannot find people to hire, even though we have raised our factory

wages by almost 30% since July. (A friend at Foxconn in Shenzhen told Li that they

raised their starting pay by 35% since March, and they are building new plants elsewhere

where unemployment is high.)

In addition, we continue to have trouble with the Samsung flash memory installation.

Unless these are handled very carefully, they can be damaged by heat during installation.

One thousand flash memories were damaged in August and had to be replaced after

inspection. Samsung is aware of this problem and has begun to install a shield to prevent

some of the damage; however, as a result, Samsung raised the price of each unit $2.00

starting in mid June. Fortunately, Apple raised our revenue recovery by an equal

amount, so this should be neutral. We apparently had a favorable variance on flash

memories and other parts.

Li is uncomfortable with this report. She feels we should prepare a new budget

showing what we would have spent using standard costs and a production volume of

180,000 units. She says that the current report (Exhibit 3) distorts how we did, and that

until we prepare a "flexible budget" to compare our actual performance to that budget

we run the risk of misinterpreting our performance.

It will take Li a couple of days to and evaluate a flexible budget because she is

working on a tax report that is due September 7. I will talk with you next week once we

receive the flexible budget from Li.

Exhibit 1	Standard Variable Costs for iPhone 4 (U.S. Dollars)
Bill of materials (per unit)
Purchased chips:
Flash memory (Samsung)	$27.00
Application processor (Samsung)	$10.75
Chip for phone calls (Infinion)	$14.05
Gryoscope (STMicroelectronics)	$2.60
8 other purchased chips	$70.95
Total	$125.35
Variable supplies and tools	$62.54
Total	$187.89
Labor:
Assembly and packaging (per unit)	$13.11
Shipping (per unit)	$1.06
Exhibit 2	Budgeted Fixed Overhead per Month
Factory Rent	$400,000
Machine depreciation	$150,000
Utility fee and local taxes	$52,000
Supervision	$127,000
Monthly fixed costs	$729,000

Exhibit 3	August 2010 Preliminary Report on the Results of Operations
	Monthly Budget 200,000 units	Actual 180,000 units	Variance 20,000
Revenue (transfer from Shenzhen)	$41,240	$37,476	$3,764	U
Variable costs
Materials
Flash memory	$5,400	$5,249	$151	F
Application process	$2,150	$1,935	$215	F
Chipsphone	$2,810	$2,529	$281	F
Gyroscope	$520	$468	$52	F
8 other chips	$14,190	$12,643	$1,547	F
Variable supplies and tools	$12,507	$11,305	$1,202	F
Subtotal	$37,577	$34,129	$3,448	F
Labor
Assembly and packaging	$2,622	$3,092	$470	U
Shipping	$212	$191	$21	F
Total variable costs	$40,411	$37,412	$2,999	F
Fixed Costs:
Factory rent	$400	$400	$0
Machine depreciation	$150	$150	$0
Utility fee and taxes	$52	$52	$0
Supervision	$127	$134	$7	U
Total fixed costs	$729	$736	$7	U
Total costs	$41,140	$38,148	$2,992	F
Net income	$100	-$672	$772	U

1. Prior to the start of production you were asked to determine the minimum number of units to be sold in order for the plant to break even. Using the budget forecast data, how many units would need to be produced, and sold, for the plant to break even?
2. Using the data provided, what would you estimate the cost per unit to be (including all overhead and shipping costs)? What were the actual costs per unit? Were the costs over-absorbed or under-absorbed? Explain.
3. The budget was prepared using a forecast of 200,000 units. As an action item from the lessons-learned meeting your manager has decided to review a worse case scenario budget in addition to the expected scenario. You've been asked to recalculate the original budget using a forecast that is 10% less than expected. Please calculate this "worse-case" budget and then compare the results to the actual performance provided in the case study.
4. Assume the labor increase for August is exactly 30% and the standard labor rate is $0.92 per hour. Examine the labor variance for August and identify how much is attributed to labor rate increase and how much is attributedto inefficiencies.
5. What are some of the strategies or decisions that should be considered in trying to solve problems with the contract? How could these impact the cost and profitability of the plant?