Our case is set in the largest and most productive division of a Fortune 500 Corporation.The corporation produces a myriad of products that it supplies to U.S and foreign governments plus some commercial customers.The division structure remained unchanged from the earlier case and is shown below.

When we last visited the division, they were wrapping up the prior year's financial performance and updating their Annual Operating Plan (AOP) forecast for the current year.At that time, there were substantial challenges for the current year in the areas of operating profit as well as a significant number of orders that had been pulled forward into the prior year.The latter action had provided a boost to current year sales but came at the expense of current year orders.

Those early bookings were allowing the division to exceed its sales plan at the mid-year point while new bookings were lagging the revised plan.Both profit and cash were lagging plan and that caused concern up through corporate.Costs seemed to be growing in the division and were the primary reason that the division was missing its cash plan - something that rarely occurred.At the current rate, the CFO estimated that the division would miss its cash plan on the order of at least several million dollars and possibly more than that.This was not insurmountable but if the growth continued, they would receive "help" from corporate.

Management believed that most of their problem was self-inflicted with the early delivery of several customer aircraft, for which the customer had paid a premium price last year.This now resulted in a "gap" in the work schedule with fewer aircraft in the hangars than originally forecast.The customer was happy but now they had direct labor manufacturing employees with nothing to do for several months.They had already made significant efforts to use them on indirect projects but that didn't solve the cash shortage.Business area leaders were briefed monthly by the manufacturing director on which labor specialties had excess people and when the schedule showed them being needed in the future.The manufacturing director pointed out that delivering aircraft early was becoming the norm and his work schedule, as well as the customer's schedule, was not reflecting this new reality.

The Business Development Vice President had identified and analyzed several medium-to-large pursuits that they had failed to win recently.He had elevated the issue of high direct labor rates at a recent staff meeting since his people were usually blamed for failing to win new business.The business area leaders piled on and said that they were seeing direct labor rates exceeding their budgets, making it a challenge to meet profit goals on their fixed price contracts.

The division CFO intervened and said that they would look at all of the costs at the next Labor & Materials Monthly Contract Review that was scheduled for next week.The review would contain the usual information but this time it would serve as the basis for potential reduction actions.This review covered not only contract efforts but also had sections towards the rear of the book for overhead costs, actual versus budgeted costs by functional area, capital equipment budgets, research & development (R&D) budgets, and ratios for production supervision versus direct labor.

As the participants filed in for the Labor & Materials Monthly Contract Review the following week, it was clear that everyone expected this meeting to be long and contentious.All knew that there would be actions required to reduce costs and there was concern about where those cuts would be accomplished.

The review began with total contract performance at the program level, and then moved to a review of direct labor for each functional area at the contract level.The business area leaders covered the contracts at the program level and then provided their assessment of comments made by the function leaders during the functional area reviews.The division President and CFO looked to the business area leaders for these amplifying remarks.

There was only one hourly rate negotiated for each functional area and that was determined by the average hourly rate of all employees classified in that category.The contract data was presented in both direct labor hours and direct labor dollars.Therefore, it became clear which functional areas had personnel working a contract whose direct labor rates exceeded the negotiated government rate.In a later review section, the negotiated hourly rate versus actual hourly rate for each functional area would be shown on one chart.This quickly indicated if a functional area's average was out-of-kilter against the negotiated average direct rates for that function.Today's review would eventually find that four functional areas were exceeding their negotiated direct labor hourly rates.Three were in engineering and one was in manufacturing support.Engineering was the most worrisome since its overhead was approximately 40% greater than Manufacturing overhead.

Two of the business area leaders cited "Function Z engineering support allocation" as a contributor to the overrun they were experiencing on their aircraft modification contracts.They said they normally had no issue with the allocation but now that they were one of the few aircraft on the field, they were carrying most of the burden of the allocation.The engineering functional leaders pointed out that 12 months from now there would be an above-average number of aircraft in the plant and these Function Z skills were difficult to find and even more difficult to train for "our particular way of doing business."The division CFO reminded everyone that no decision on cuts or reductions would be made today and that this meeting was to identify issues and concerns that could be addressed going forward.

The second area of the review covered Material.Much of it centered around the fact that many of their Time & Material (T&M) contracts were bid as a combination of labor and material guesstimates.Often the labor content went unrealized and was used to purchase materials, to the dismay of the Finance people who forecast overhead rates and operating profits.There was also the fact that this type of contract did not support fee on materials.

There was some abbreviated discussion on allocated material and whether it was set correctly for the aircraft modification contracts.The division Chief Operating Officer spoke up and assured everyone that it was still a good bid factor and they did not want to be in the business of counting every nut, bolt, and rivet that went into the aircraft modification and overhaul.He said that the few contracts overrunning allocated material were due to excessive rework and scrap, but it was not a trend.

The group moved on to the next section of the book - Capital Expenditures Budget.The capital budget for the year had been trimmed back but not by a significant amount.It still amounted to 2.5% of revenues spent on capital expenditure.Expenditures to-date had been approximately 25% of budget plus there were commitments of another 10% of budget.The budget contained business area items for new laboratories, remodeled facilities, fixtures, equipment, etc.Of course, the business area leaders felt that every one of their projects should be accomplished now and often cited the fact that they had already told their customer(s) about the project.It also contained many plant infrastructure items since the facility was basically a small city, some of which dated back to 1942.The Facility Resource Manager, responsible for the overall Capital Expenditures Budget, spoke to each of the infrastructure projects, citing the reason for repair, replacement, or improvement.He noted the ones that absolutely must be executed in the current year, and the ones that could possibly be delayed and the consequences of that delay.The functional area leaders spoke to each of the projects that they had in the budget and again cited the reasons that they could not be postponed.Many of their requests were for test equipment and remodeled facilities.Several of these requests had been in previous capital requests and deferred.

R&D was the next section to be reviewed after a short break to bring in the R&D task leaders.R&D was funded at approximately 3% of revenues and, as usual, expenditures at mid-year were approximately 35% of budget.Many of the projects were multi-year undertakings and one was for a multi-year aircraft modification effort that was consuming one-third of this year's budget.This effort was in its third year and had encountered several technical challenges resulting in a modification cost that was twice the original estimate with less capability than originally envisioned.The increased costs had captured corporate's attention and they had been assured by the previous president, subsequently promoted up one level, that there was a market for this aircraft modification.The launch customer and intended purpose had changed since the project was originally funded and it was unclear if the new-targeted launch customer was committed to the project.Most of the other projects were enhancements to special-purpose electronic capabilities that one of the customers would then fund if proven.Each task leader gave a brief summation of their project and all indicated that their project had program office endorsement.Many of the engineers working R&D had not worked on customer-funded projects in several years and if their R&D projects were cancelled, they would need to have replacement tasks found and assigned.

The division CFO then directed the group's attention to the section of the book titled "Finance."The first page was top-level overhead expenditures by department.It reflected total budget, year-to-date (YTD) budget, and YTD expenditures.All but two departments were at or slightly below their YTD budget targets.The following page detailed the overhead expense categories by department.The CFO concentrated on the following expense categories:Training, Direct-On-Indirect (DOI) Labor, and Travel.The division's mandatory annual ethics training had a cut-off date of 15 June for completion, so it was now finished.Some functional areas still had remaining training and travel budgeted for the second half of the year.The CFO concentrated on the DOI labor that he considered far too high.DOI meant that direct labor employees were charging their time to indirect labor activities, such as personal appointments outside the plant, vacation, or other activities that could not be charged directly to a customer contract.Both Engineering and Manufacturing were exceeding their budgets, Manufacturing by many hundreds of thousands of dollars while Engineering was exceeding by tens of thousands of dollars.The COO said that he understood that the overrun of manufacturing overhead was a concern but that these employees would be needed when the plant ramped back up to its normal workload over the next year.It wasn't like the "old days" when all of his people had ranches and farms that they worked when they were laid off.Then they would return when the workload picked back up.Nowadays with the certifications required, these people could find other employment, often for better pay, and would not return when they were needed here.He pointed out that the customer knew most of his people personally and would not be happy if they let them go.He said that the Engineering overrun was a timing issue with the summer since his engineers were taking their Paid Time Off (PTO) since their kids were out of school.He said he'd talk to his managers because they had not spread the labor hours correctly and they knew better than that.

The division president closed the meeting after reviewing the number of Indirect Labor employees, and sales-per-employee pages.The number of Indirect Labor employees remained constant (~14% of total employees) and within plan.The president closed the meeting and stated that they would reconvene in a few days to finalize an action plan.

Student Questions:

1.How would you frame the problem facing management?

2.What issues should be evaluated further for cost reduction initiatives and why?

3.In what order would you prioritize the evaluation of these initiatives?

4.What are the risks for each area recommended for reduction?

5.What additional information, if any, would you request to take action?