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Sippican Corporation The decline in our profits has become intolerable. The severe price cutting in pumps has dropped our pre-tax margin to less than 2%, far below our historical 15% margins. Fortunately, our competitors are overlooking the opportunities for profit in flow controllers. Our recent 10% price increase in that line has been implemented without losing any business. Robert Parker, President of Sippican Corporation Robert Parker was discussing operating results in the latest month with Peggy Knight, his controller, and John Scott, his manufacturing manager. The meeting among the three was taking place in an atmosphere tinged with apprehension because competitors had been reducing prices on pumps, Sippican's major product line. Since pumps were a commodity product, Parker had seen no alternative but to match the reduced prices to maintain volume. But the price cuts had led to declining company profits, especially in the pump line (summary operating results and product profitability analysis for the month of March 2006, are shown in Exhibits 1-1 and 12). Exhibit 1-1 Sippican Corporation: Operating Results (March 2006) Sales $1,847,500 Direct labour expense 351,000 Direct materials expense 458,000 Total Variable costs 809,000 Contribution Margin $1,038,500 Manufacturing Overhead Machine - related expenses $334,800 Setup labour 117,000 Receiving and Production control 15,600 Engineering 78,000 Packaging and shipping 109,200 Total Manufacturing Overhead $654,600 Gross Margin $383,900 General Selling and Administrative expenses 350,000 Operating Income (Pretax) $33,900 100% 56% 35% Source: Robert S. Kaplan 1 Exhibit 1-2 Product Profitability analysis (March 2006) Valves Pumps a Direct Labour cost Direct Material cost Manufacturing Overhead (at 185%) Standard unit costs Target selling price Planned Gross Margin (%) Actual Selling Price Actual Gross Margin Actual Gross Margin (%) $12.35 $16.00 $22.85 $51.20 $78.77 35% $79.00 $27.80 35% $16.25 $20.00 $30.06 $66.31 $102.02 35% $70.00 $3.69 5% Flow Controllers $13.00 $22.00 $24.05 $59.05 $90.85 35% $95.00 $35.95 38% a Direct labour costs were charged at $32.50 per hour. The average daily compensation for days worked was $195 per day ($3,900 per month divided by 20 working days per month). The hourly rate was calculated by dividing $195 by the 6 hours per day available for productive work. Source: Robert S. Kaplan Sippican supplied products to manufacturers of water purification equipment. The company had started with a unique design for valves that it could produce to tolerances that were better than any in the industry. Parker quickly established a loyal customer base because of the high quality of the company's manufactured valves. He and Scott realized that Sippican's existing labour skills and machining equipment could also be used to produce pumps and flow controllers, products that were also purchased by its customers. They soon established a major presence in the highvolume pump product line and the more customized flow controller line. Sippican's production process started with the purchase of semi-finished components from several suppliers. It machined these parts to the required tolerances and assembled them in company's modern manufacturing facility. The same equipment and labour were used for all three product lines, and production runs were scheduled to match customer shipping requirements. Suppliers and customers had agreed to justin-time deliveries, and products were packed and shipped as completed. Valves were produced by assembling four different machined components. Scott had designed machines that held components in fixtures so that they could be machined automatically. The valves were standard products and could be produced and shipped in large lots. Although Scott felt several competitors could now match Parker's quality in valves, none had tried to gain market share by cutting price, and gross margins had been maintained at a standard 35%. 2 The manufacturing process for pumps was practically identical to that for valves. Five components were machined and then assembled into the final product. The pumps were shipped to industrial product distributors after assembly. Recently, it seemed as if each month brought new reports of reduced prices for pumps. Sippican had matched the 1ower prices so that it would not give up its place as a major pump supplier. Gross margins on pump sales in the latest month had fallen to about 5%, well below the company's planned gross margin of 35%. Flow controllers were devices that controlled the rate and direction of flow of chemicals. They required more components than pumps or valves and more components for labour than valves, for each finished unit. Also, there was much more variety in the types of flow controllers used in industry, so many more production runs and shipments were performed for this product line than for valves. Sippican had recently raised flow controller prices by more than 10% with no apparent effect on demand. Sippican had always used a simple cost accounting system. Each unit of product was charged for direct material and labour cost. Material cost was based on the prices paid for components under annual purchasing agreements. Labour rates, including fringe benefits, were $32.50 per hour1 and were charged to products based on the standard run times for each product (see Exhibit 1-3). The company had only one producing department, in which components were both machined and assembled into finished products. The overhead costs in this department were allocated to products as a percentage of production-run direct labour cost. Currently, the rate was 185%. Since direct labour cost had to be recorded anyway to prepare factory payroll, this was an inexpensive way to allocate overhead costs to products. Knight noted that some companies didn't allocate any overhead costs to products, treating them as period, not product, expenses. For these companies, product profitability was measured at the contribution margin level-price less all variable costs. Sippican's variable costs were only its direct material and direct labour costs. On that basis, all products, including pumps, would be generating substantial contribution to overhead and profits. She thought that perhaps some of Sippican's competitors were following this procedure and pricing to cover variable costs. 3 Product Lines Materials per unit Materials cost per unit Direct labour per unit Machine hours per unit Setup hours per run Source: Robert S. Kaplan Exhibit 1-3 Product Data Valves Pumps 4 components 5 components 2 at $2 each = $4 3 at $2 each = $6 2 at $6 each = $12 2 at $7 each = $14 $16 0.38 DL hours 0.5 5 $20 0.50 DL hours 0.5 6 Flow Controllers 10 components 4 at $1 each = $4 5 at $2 each = $10 1 at $8 each = $8 $22 0.40 DL hours 0.3 12 Knight had recently led a small task force to study Sippican's overhead costs since they had now become much larger than the direct labour expenses. The study had revealed the following information: 1. A setup had to be performed each time a batch of components had to be machined in a production run. Each component in a product required a separate production machine to run the raw material or purchased part to the specifications for the product. Workers often operated several of the machines simultaneously once they had set up the machine. Because of the large number of setups, Sippican had dedicated about 25% of its production work force to focus exclusively on setups. Some production workers did not operate any machines; they performed only manual assembly work. Their assembly time per product was included in the direct labour hour estimates for each product. Sippican operated two 7.5 hour shifts each weekday. Each shift employed 45 production and assembly workers, plus 15 setup workers. Workers received two 15-minute breaks each day. They received an average of 30 minutes per day for training and education activities, and all the workers (production, assembly, and setup) spent 30 minutes each shift for preventive maintenance and minor repair of the machines. 2. The company had 62 machines for component processing. These machines were generally available for the six hours per shift that production workers were actively engaged in production or setup activities on the machines. Sippican leased the machines. Each machine's operating expenses were about $5,400 per month, including lease payments, supplies, utilities, and maintenance and repairs. 3. The receiving and production control departments employed four people over the two shifts. These personnel ordered, processed, inspected, and moved each batch of components for a production run. It took a total of 75 minutes for all the activities required to get one batch of components ordered, received and moved to a machine for processing. This time was independent of whether the components were for a long or a short production run, or whether the components were expensive or inexpensive. 4 4. The work in the packaging and shipping area had increased during the past couple of years as Sippican increased the number of customers it served. Each shipment took 50 minutes to prepare the packages and labels, independent of the number or types of items in the shipment, plus eight minutes per item to bubble wrap and pack in the carton, whether the item was a valve, pump, or flow controller. The packaging and shipping area employed 14 people in each of the two shifts (28 in total). Employees in the receiving, production control, packaging, and shipping departments worked a 7.5 hour shift that included two 15 minute breaks per day, and 30 minutes on average, for training and education. 5. Sippican employed eight engineers for designing and developing new product varieties. Engineers' total compensation was $9,750 per month. Much of their time was spent modifying flow control products to conform to customer requests. Engineers worked 7.5 hour shifts per day. After breaks, training, education, and professional activities, engineers supplied about 6 hours of productive work per shift per day. Knight's team had collected the data shown in Exhibit 1-4 based on operations in March 2006.The team felt that this month was typical of ongoing operations. Exhibit 1-4 Monthly Production and Operating Statistics (March 2006) Valves Pumps Flow Controllers Production (units) 7,500 12,500 4,000 Machine hours (run time) 3,750 6,250 1,200 Production runs 20 100 225 Setup hours (labour and machines) Number of shipments Hours of engineering work 100 40 60 600 100 240 2,700 200 600 Source: Robert S. Kaplan Required: 1. Should executives abandon overhead assignment to products entirely and adopt a contribution margin approach in which manufacturing overhead is treated as a period expense? Why or why not? 2. Instead, should they adopt an activity-based costing approach? If so, what cost pools and drivers would you recommend to assign overheads to the three product lines? 3. Calculate the practical capacity and the capacity cost rates for each of Sippican's resources: production and service employees, machines, receiving and production control employees, shipping and packaging employees and engineers. 4. Using the rates determined in 2, what are the costs for each of the three products lines? 5. What differences will this cost assignment approach have on product costs, pricing decisions and profitability? 5 Total 24,000 11,200 345 3,400 340 900