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Should Mamoun Company lower as of January 1, 2016 its price of product A? To what price and why?
NTRODUCTION: In February 2015, Majdy I. was appointed as a Chief Executive Manager of the Manufacturing Company by Mamoun N., President. Majdy had wide executive experience in the manufacturing sector with high level of experience in products similar to those of Mamoun's company. The appointment of Majdy resulted from management president of the company. The president had only four years experience with the company, and in early 2015 was 34 years old in which he exercised full control until he hired Majdy. Mamoun knew that during 2014 he had made several poor decisions and noted that morale of the organization had suffered, apparently through lack of confidence in him. When he received the income statement for 2014 (see Exhibit 1) showing a net loss of 688 during a good business year, he knew he needed help. He attracted Majdy from a competitor by offering a stock option incentive in addition to salary, knowing that Majdy wanted to acquire a financial competence for his retirement. The president came to a clear understanding that Majdy would explain the reasons for his decisions and thereby train the president for successful leadership upon Majdys retirement. Upon taking office in February 2015, Majdy decided against immediate major changes. Rather, he chose to analyze 2014 operations and to wait to see results for the first half of 2015. He instructed the accounting departments for 2014. In addition, he requested an explanation of the nature of the companys costs including their expected future behavior. RELEVANT INFORMATION ON INDUSTRY: Mamoun Manufacturing Company made only three industrial products: A, B, and C. They were sold by the companys sales force for use in the processes of other manufacturing companies. All of the sales force, on a salary basis, sold the three products but in varying proportions. The company sold throughout Jordan and was one of eight companies with similar products. Several of its competitors were larger and manufactured a larger variety of products than did Mamoun company. The dominant company was Sam company, which operated a branch plant in the companys market area. Customarily, Sam Company announced prices annually, and the other producers followed that. Price cutting was rare, and the only variance from quoted selling prices took the form of cash discounts. In the past, attempts at price cutting had followed a consistent pattern: all competitors met the price reduction, and the industry as a whole sold about the same quantity but at the lower prices. This continued until Sam Company, with its strong financial position, again stabilized the situation following a general recognition of the failure of price-cutting. Furthermore, because sales were to industrial buyers and because the products of different manufacturers were very similar, Majdy was convinced that Mamoun's company could not individually raise prices without suffering substantial sales volume declines. During 2014, Mamouns share of industry sales was 12% for product A, 8% for product B, and 10% for product C. The industrywide quoted selling prices were $24.50, $25.80 and $27.50 per 100 kilograms of product, respectively. MANUFACTURING STRATEGY: Mamouns manufacturing strategy was based on producing each of the three products in its own facility complex within the total general factory complex. The three product factories were referred to as A factory, B factory, and C factory. Each of these product factories was horizontally integrated beginning with receiving and extending through raw material storage, production-process facilities, finished-product inventory, and shipping. In addition, each product factory had a dedicated direct labor force, which for accounting purposes included hourly workers, shift managers, and other manufacturing-related personnel assigned to each product factory. Indirect labor floated between product factories as needed. Typically, Mamouns manufacturing facilities operated below capacity. COSTING SYSTEM: Mamouns manufacturing Company maintained a simple cost system. It was used for strategic planning, product-line decisions, identifying manufacturing process-improvement opportunities profitability analysis, performance evaluation, cost control, and inventory valuation purposes. Managements goal was to assign all of the companys costs to each of the three products in a way that would lead to the most useful product costs for the cost systems various managerial purposes. The cost system identified two categories of costs. The first category consisted of costs, such as material costs, that could be tied directly to the manufacture of specific products. All other costs were placed in the second category and referred as indirect costs (see Exhibit 2). The cost system accumulated direct and indirect costs at the product-factory level before determining the individual product costs on a per unit basis. Since each of three products was sold in 100-kilograms bags, per unit costs were expressed in terms of 100 kilograms of finished product. The per unit cost was calculated by dividing the unit output into the respective product factorys total cost. Total cost was the sum of the product factorys direct costs plus allocated indirect costs less an allocated other-income amount. Allocated indirect costs included the companys interest cost related to bank loans. Costs designed as direct costs were assigned directly to the product factory in which they were incurred. For example, the cost of materials used to manufacture product A in its factory and was charged directly to the A factory account. This material cost could be traced directly to A factory through material purchase and requisition orders. Indirect costs were allocated to the product factories using a variety of allocation methods. For example, the total company rent expense ($5,324,000) was allocated to each product factory based on its enclosed cubic space. Cubic space was selected as the allocation basis to capture the fact that the production process for each of the three products included enclosed scrubber towers that varied in height depending on the product produced. Using the cubic space as the allocation base, the total company rent was charged as shown in Figure A to each product factory.
The allocated per 100-kilograms rent cost of each product was derived by dividing the unit output of each product factory into the respective product factorys allocated rent. A standard (Target) cost system was introduced in early 2015. It was used to value inventories, prepare budgets, and analyze performance (see Exhibit 4). Next years standard costs were last years actual per unit costs adjusted for anticipated cost changes. Since Mamouns three products were each sold in 100-kilogram bags, per unit standards were expressed in terms of 100 kilograms of finished product.
DROP PRODUCT C: To Familiarize Mamoun with his methods, Majdy sent copies of Exhibits 2 & 3 to Mamoun, and they discussed them. Mamoun stated that he thought product C should be dropped immediately, as it would be impossible to lower expenses on product C as much as $2.16 per 100 kilograms. In addition, he stressed the need for economies on product B. Majdy relied on the authority arrangement Mamoun had agreed to earlier and continued production of the three products. SEMI-ANNUAL RESULTS: In the first week of July 2015, Majdy received from the accounting department the six months statement of cumulative standard costs including variances of total company actual costs from standard (see Exhibit 4). It showed that the first half of 2015 had been a successful period. In order to expedite the availability of interim-period results, the company did not determine actual product-line revenues, costs, and profits. Rather, product-line data was prepared using standard per unit data and actual unit sales. REDUCE THE PRICE OF PRODUCT A: During the latter half of 2015, the sales of the entire industry weakened. Even though Mamoun manufacturing company retained its share of the market, its profit for the last six months was expected to be small. In November 2015, Sam Company announced a price reduction as of January 1, 2016 on product A from $24.50 to $22.50 per 100 kilograms. This created a pricing problem for all its competitors. Majdy forecast that if the company held to the $24.50 price during the first 6 months of 2016, the companys unit sales would be $750,000. He felt that if we drop the price to $22.50, the six months unit volume would be 1 million. Majdy knew that competing companies anticipated a further decline in activity. He thought a general decline in prices of all products was quite probable. The accounting department reported that the standard costs in use would probably apply during 2016, with two exceptions: materials and supplies would be about 5% below the 2015 standard. Majdy and Mamoun discussed the pricing problem. Mamoun observed that even with the anticipated decline in material and supply costs, a sales price of $22.50 would be below cost. Mamoun therefore wanted the $24.50 price to be continued, since he felt the company could not be profitable while selling a key product below cost.
Should Mamoun Company lower as of January 1, 2016 its price of product A? To what price and why?
Figure A: Total Company Actual Rent Expense $5,324,000 Allocation Basis (Cubic Space) Allocated Rent to Factory A $1,872.000 Allocated Rent to Factory B $1,570,000 Allocated Rent to Factory C $1,882,000 Exhibit 1 income statement for year ending December 31, 2014 (in thousands) $105,905 (1.567 $104,338 (65,251) $39,087 Gross sales Cash Discount Net Sales Cost of Manufacturing Gross profit Less: Selling Expense General Administration Depreciation Operating Profit Plus: Other Income Net Profit before Interest Less: Interest $18,383 6,534 13.591 (38,508) $579 205 $784 (1.472) Net Income (6688) Exhibit 2 Analysis of income statement by products and departments-Year ended December 31, 2014 thousands $ except per 100 kilograms.) Product A Per 100 kgs. Product B Per 100 kgs. Product C Per 100 kgs. Classification Direct Indirect Total Allocation Basis Cubic space Area value of equipment Direct labor (5) Direct labor (5) Machine horsepower Area Area Rent Property Taxes Property Insurance Compensation Insurance Direct Labor Indirect Labor Power Light & Heat Building Service Materials Supplies Repairs Total Selling Expense General Administrative Depreciation Interest Total Cost Less: Other Income $ 1.872 621 524 836 12,937 4,413 220 158 109 7641 525 184 $30,040 9,100 3,451 5,659 524 $48,774 101 $48,673 51,672 $2.999 2,132,191 $24.50 1.0896 $.88 .29 .25 .39 6.06 2.07 .11 .07 .05 3.59 .25 .08 $14.09 4.27 1.62 2.65 -25 $22.88 .04 $1,570 503 405 439 6,107 2,124 251 130 82 4,716 485 150 $16,962 4,582 1,300 4,274 409 $27,527 53 $27,474 25,996 (1,478) 1,029,654 $25.80 2.1496 $1.53 .49 39 .42 5.92 2.06 .24 .12 .08 4.58 .46 . 15 $16.44 4.44 1.26 4.16 39 $26.69 .05 $26.64 25.23 ($1.41) $1,882 401 534 458 6,879 2,309 302 106 75 4,851 350 104 $18,251 4,701 1,783 3,658 539 $28,932 51 $28,881 26,670 ($2,211) 986,974 $27.50 1.7496 $1.90 .40 .53 .46 6.97 2.33 .31 . 10 .08 4.91 .36 .10 $18.45 4.76 1.80 3.70 .53 $29.24 .05 $29.19 27.03 ($2.16) $5,324 1,525 1,463 1,733 25,921 8,846 773 394 266 17,208 1,360 438 $65,251 18,383 6,534 13,591 1,472 $105,231 205 $105,026 104,338 ($688) $ Value of sales $ Value of sales Value of equipment value of equipment $ Value of sales $22.84 24.24 $1.40 Sales (Net) Profit (Loss) Unit Sales (100 kgs.) Quoted Selling Price Per Unit Cash Discount Taken (% of Selling Price) 1.48% Exhibit 3: Accounting Department's Commentary on Costs Direct Labor: Variable. Union shop at going community rates. No abnormal demands foreseen. It may be assumed that direct labor dollars are an adequate measure of capacity utilization. Compensation Insurance: Variable. Five percent of direct and indirect labor is an accurate estimate Materials: Variable. Exhibit 2 figures are accurate. Includes waste allowances. Purchase are at market prices Power: Variable. Rates are fixed. Use varies with activity. Averages per Exhibit 2 are accurate. Supplies: Variable. Exhibit 2 figures are accurate. Supplies bought at market prices. Repairs: Variable. Varies as volume changes within normal operation range. Lower and upper limits are fixed. General Administrative, Selling Expense, Indirect Labor, Interest, and Other income: These items are almost non-variable. They can be changed, of course, by management decision. Cash Discount: Almost non-variable. Average cash discount taker are consistent from year to year. Percentages in Exhibit 2 are accurate. Light and Heat: Almost non-variable. Heat varies slightly with fuel cost changes. Light a fixed item regardless of level of production. Property Taxes: Almost non-variable. Under the lease terms superior pays the taxes; assessed valuations have been constant; the rate has risen slowly. Any change in the near future will be small and independent of production volume. Rent: Non-variable. Lease has 12 years to run Building service: Non-variable. At normal business level, variances are small. Property Insurance: Non-variable. Three-year policy with fixed premium. Depreciation: Non-variable. Fixed dollar total. Exhibit 4 Income statement by products and departments at standard and total company variances from January 1 to June 30, 2015 (Thousands $ except per 100 kgs.) Item Product A Standard Total at Per 100 kgs. Standard Total Standard $2,919 Total Actual $2,660 349 201 839 770 793 919 2.33 13,751 4,698 435 205 .05 147 Rent $.88 $877 Property Tax .29 299 Property Insurance .25 249 Compensation Insurance .39 389 Direct Labor 6.06 6,041 Indirect Labor 2.07 2,063 Power .11 109 Light & Heat .07 70 Building Service 50 Materials 3.59 3,579 Supplies .25 239 Repairs .08 79 Total $14.09 $14,034 Selling Expense 4.27 4,257 General Administrative 1.62 1,615 Depreciation 2.65 2,642 Interest .25 249 Total Cost $22.88 $22,797 Less: Other Income .04 40 $22.84 $22.757 Actual Sales (net) 24.24 24,164 Profit Loss $1.40 $1,407 Unit Sales (100 kgs.) 996,859 a: Actual unit sales times standard net revenue per unit Product B Standard Total at Per 100 kgs. Standard $1.53 $1,090 .49 -39 278 .42 299 5.92 4,216 2.06 1,467 .24 171 .12 85 .08 57 4.58 3,216 .46 328 .15 107 $16.44 $11,708 4.44 3,162 1.26 897 4.16 2,962 .39 278 $26.69 $19,007 .05 36 $26.64 $18,971 25.23 17,961 ($1.41) ($1,010) 712,102 Product C Standard Total at Per 100 kgs. Standard $1.90 $952 .40 .53 266 .46 231 6.97 3,496 1,168 .31 155 .10 50 .08 40 4.91 2,461 .36 180 .10 50 $18.45 $9,248 4.76 2,336 1.80 902 3.70 1,855 .53 266 $29.24 $14,657 .05 25 $29.19 $14,632 27.03 13,550 ($2.16) ($1,082) 501,276 9,301 747 236 $34,990 9,805 3,414 7,459 793 $56,461 101 $56,360 55,657 ($685) 732 917 13,820 4,485 432 200 107 9,232 750 251 $34,406 9,830 3,289 6,817 730 $55,072 110 $54,962 55,675 $713 AB Total $ 51,672 $25,996 $26,670 $104,338 344 647 12,937 7,641 6,877 4,851 302 220 305 6,107 4,716 251 485 150 $ 12,014 $ 13,982 525 184 $ 22,154 $ 29,518 350 1,296 25,921 17,208 773 1,360 438 $ 46.996 $57,342 104 $ 12.828 $ 13,842 Sales (net) Variable Costs Compensation Insurance Direct Labor Materials Power Supplies Repairs Total Variable costs Contribution Fixed Expenses Compensation Insurance ($1,733-1,206) Ront Proporty Taxos Property Insurance Indirect Labor Light and Heat Building Service Selling Expense General Administration Depreciation Interest Total Fixed Expenses Other Income Net Loss 437 5,324 1,525 1,463 8,846 394 266 18,383 6,534 13,591 1.472 $ 58,235 205 $ 689 Figure A: Total Company Actual Rent Expense $5,324,000 Allocation Basis (Cubic Space) Allocated Rent to Factory A $1,872.000 Allocated Rent to Factory B $1,570,000 Allocated Rent to Factory C $1,882,000 Exhibit 1 income statement for year ending December 31, 2014 (in thousands) $105,905 (1.567 $104,338 (65,251) $39,087 Gross sales Cash Discount Net Sales Cost of Manufacturing Gross profit Less: Selling Expense General Administration Depreciation Operating Profit Plus: Other Income Net Profit before Interest Less: Interest $18,383 6,534 13.591 (38,508) $579 205 $784 (1.472) Net Income (6688) Exhibit 2 Analysis of income statement by products and departments-Year ended December 31, 2014 thousands $ except per 100 kilograms.) Product A Per 100 kgs. Product B Per 100 kgs. Product C Per 100 kgs. Classification Direct Indirect Total Allocation Basis Cubic space Area value of equipment Direct labor (5) Direct labor (5) Machine horsepower Area Area Rent Property Taxes Property Insurance Compensation Insurance Direct Labor Indirect Labor Power Light & Heat Building Service Materials Supplies Repairs Total Selling Expense General Administrative Depreciation Interest Total Cost Less: Other Income $ 1.872 621 524 836 12,937 4,413 220 158 109 7641 525 184 $30,040 9,100 3,451 5,659 524 $48,774 101 $48,673 51,672 $2.999 2,132,191 $24.50 1.0896 $.88 .29 .25 .39 6.06 2.07 .11 .07 .05 3.59 .25 .08 $14.09 4.27 1.62 2.65 -25 $22.88 .04 $1,570 503 405 439 6,107 2,124 251 130 82 4,716 485 150 $16,962 4,582 1,300 4,274 409 $27,527 53 $27,474 25,996 (1,478) 1,029,654 $25.80 2.1496 $1.53 .49 39 .42 5.92 2.06 .24 .12 .08 4.58 .46 . 15 $16.44 4.44 1.26 4.16 39 $26.69 .05 $26.64 25.23 ($1.41) $1,882 401 534 458 6,879 2,309 302 106 75 4,851 350 104 $18,251 4,701 1,783 3,658 539 $28,932 51 $28,881 26,670 ($2,211) 986,974 $27.50 1.7496 $1.90 .40 .53 .46 6.97 2.33 .31 . 10 .08 4.91 .36 .10 $18.45 4.76 1.80 3.70 .53 $29.24 .05 $29.19 27.03 ($2.16) $5,324 1,525 1,463 1,733 25,921 8,846 773 394 266 17,208 1,360 438 $65,251 18,383 6,534 13,591 1,472 $105,231 205 $105,026 104,338 ($688) $ Value of sales $ Value of sales Value of equipment value of equipment $ Value of sales $22.84 24.24 $1.40 Sales (Net) Profit (Loss) Unit Sales (100 kgs.) Quoted Selling Price Per Unit Cash Discount Taken (% of Selling Price) 1.48% Exhibit 3: Accounting Department's Commentary on Costs Direct Labor: Variable. Union shop at going community rates. No abnormal demands foreseen. It may be assumed that direct labor dollars are an adequate measure of capacity utilization. Compensation Insurance: Variable. Five percent of direct and indirect labor is an accurate estimate Materials: Variable. Exhibit 2 figures are accurate. Includes waste allowances. Purchase are at market prices Power: Variable. Rates are fixed. Use varies with activity. Averages per Exhibit 2 are accurate. Supplies: Variable. Exhibit 2 figures are accurate. Supplies bought at market prices. Repairs: Variable. Varies as volume changes within normal operation range. Lower and upper limits are fixed. General Administrative, Selling Expense, Indirect Labor, Interest, and Other income: These items are almost non-variable. They can be changed, of course, by management decision. Cash Discount: Almost non-variable. Average cash discount taker are consistent from year to year. Percentages in Exhibit 2 are accurate. Light and Heat: Almost non-variable. Heat varies slightly with fuel cost changes. Light a fixed item regardless of level of production. Property Taxes: Almost non-variable. Under the lease terms superior pays the taxes; assessed valuations have been constant; the rate has risen slowly. Any change in the near future will be small and independent of production volume. Rent: Non-variable. Lease has 12 years to run Building service: Non-variable. At normal business level, variances are small. Property Insurance: Non-variable. Three-year policy with fixed premium. Depreciation: Non-variable. Fixed dollar total. Exhibit 4 Income statement by products and departments at standard and total company variances from January 1 to June 30, 2015 (Thousands $ except per 100 kgs.) Item Product A Standard Total at Per 100 kgs. Standard Total Standard $2,919 Total Actual $2,660 349 201 839 770 793 919 2.33 13,751 4,698 435 205 .05 147 Rent $.88 $877 Property Tax .29 299 Property Insurance .25 249 Compensation Insurance .39 389 Direct Labor 6.06 6,041 Indirect Labor 2.07 2,063 Power .11 109 Light & Heat .07 70 Building Service 50 Materials 3.59 3,579 Supplies .25 239 Repairs .08 79 Total $14.09 $14,034 Selling Expense 4.27 4,257 General Administrative 1.62 1,615 Depreciation 2.65 2,642 Interest .25 249 Total Cost $22.88 $22,797 Less: Other Income .04 40 $22.84 $22.757 Actual Sales (net) 24.24 24,164 Profit Loss $1.40 $1,407 Unit Sales (100 kgs.) 996,859 a: Actual unit sales times standard net revenue per unit Product B Standard Total at Per 100 kgs. Standard $1.53 $1,090 .49 -39 278 .42 299 5.92 4,216 2.06 1,467 .24 171 .12 85 .08 57 4.58 3,216 .46 328 .15 107 $16.44 $11,708 4.44 3,162 1.26 897 4.16 2,962 .39 278 $26.69 $19,007 .05 36 $26.64 $18,971 25.23 17,961 ($1.41) ($1,010) 712,102 Product C Standard Total at Per 100 kgs. Standard $1.90 $952 .40 .53 266 .46 231 6.97 3,496 1,168 .31 155 .10 50 .08 40 4.91 2,461 .36 180 .10 50 $18.45 $9,248 4.76 2,336 1.80 902 3.70 1,855 .53 266 $29.24 $14,657 .05 25 $29.19 $14,632 27.03 13,550 ($2.16) ($1,082) 501,276 9,301 747 236 $34,990 9,805 3,414 7,459 793 $56,461 101 $56,360 55,657 ($685) 732 917 13,820 4,485 432 200 107 9,232 750 251 $34,406 9,830 3,289 6,817 730 $55,072 110 $54,962 55,675 $713 AB Total $ 51,672 $25,996 $26,670 $104,338 344 647 12,937 7,641 6,877 4,851 302 220 305 6,107 4,716 251 485 150 $ 12,014 $ 13,982 525 184 $ 22,154 $ 29,518 350 1,296 25,921 17,208 773 1,360 438 $ 46.996 $57,342 104 $ 12.828 $ 13,842 Sales (net) Variable Costs Compensation Insurance Direct Labor Materials Power Supplies Repairs Total Variable costs Contribution Fixed Expenses Compensation Insurance ($1,733-1,206) Ront Proporty Taxos Property Insurance Indirect Labor Light and Heat Building Service Selling Expense General Administration Depreciation Interest Total Fixed Expenses Other Income Net Loss 437 5,324 1,525 1,463 8,846 394 266 18,383 6,534 13,591 1.472 $ 58,235 205 $ 689
