Please help answer The superior valve division case

The Superior Valve Division In 2009, the Superior Valve Division of the Able Corporation found itself in a position typical of fastgrowing companies. Although sales revenues were increasing rapidly, capital equipment allocations from Able were less than desired, and profits were variable. Jerry Conrad, the general manager of the division, enrolled that year in a seminar on contribution margin income sponsored by the American Management Association (AMA). According to Conrad, "Before I went to that seminar, my knowledge of contribution margin income was limited to casual comments that I overheard at group general managers' meetings. A large acquisition in the automotive aftermarket industry had always used a contribution margin approach in its accounting systems. All other segments of the Able Corporation used the full costing method, but this company was allowed to keep its contribution margin cost system because a forced change of systems at the time of acquisition would have been too disruptive." Jerry believed that the full cost reports used in his division were accurate. He and Frances Kardell, the Division Controller, were confident they knew the total manufacturing cost of each of their products. However, Jerry did not have the same confidence in his staff's ability to determine how volume changes would affect profits. He was convinced that better utilization of plant and equipment and a more effective pricing structure would lead to substantially improved earnings. The division was not as profitable as others in the industry or other similar-size divisions in the corporation that had comparable manufacturing processes. A main point of the AMA seminar was that product lines do not produce profits; they produce contribution margin (sales revenue minus variable costs), which can become profits only after fixed costs are covered. The seminar also underscored not only the importance of cost behavior analysis but also the arbitrariness of many fixed cost allocations. Jerry immediately saw in contribution margin a new approach to solving Superior Valve's problems with both product mix and pricing decisions. Jerry discussed the subject of contribution margin with Todd Talbott, the Group Controller. After hearing the advantages and disadvantages of the approach, Jerry recommended that his division's product costing system be overhauled for the third time since Able Corporation acquired Superior Valve 20 years ago. Todd agreed to support a change in the management reporting system, but he pointed out that the contribution margin approach was contrary to the reporting philosophy of the corporation and, for external purposes, did not comply with GAAP, S.E.C. reporting requirements, and Internal Revenue Service directives on inventory valuation. When the decision to proceed was made, Frances and her accounting staff used regression analysis to classify manufacturing costs, other operating costs, and selling and general administration costs as either variable, fixed, or mixed. Mixed costs were separated into their variable and fixed components. Fixed costs then were identified as either discretionary (amounts to be expended based on decisions made annually or at shorter intervals) or committed (usually not subject to change in the short-run). A booklet on contribution margin which Jerry gave to his staff stated that fixed expenses are a function of time, and variable expenses (1) vary directly with changes in volume and (2) are usually expressed as a percentage of sales dollars or direct labor dollars. SPECIAL ORDER The Wadsworth Company, which was experimenting with various components of its product line, offered to purchase 6,000 Hydro-Con multi-function control valves from Superior for $160 each. Wadsworth would need 500 units per month with delivery commencing at the start of the new year. The special order would be in addition to the 80,000 units that Ralph Darwin, the division's Marketing Manager, expected to sell at the regular $200 price. Ralph considered the order to represent an excellent opportunity to increase long-term sales volume because it would be a new application for the product. He negotiated a flat $48,000 commission with the selling distributor. Jerry was concerned that cutting the price of the valve would set an undesirable precedent. He pondered the special deal for several days before going to see Ralph. "The price is below our full cost of $175 per unit," he said. "If we accept the Wadsworth proposal, the firm can always expect favored treatment." Jerry asked Daria Good, the Manufacturing Manager, and Frances to join this discussion in Darwin's office. When they arrived, he asked, "What is the division's capacity for making Hydro-Con Control?" Good's reply was "One hundred thousand (100,000) units per year, if we don't retool any machines dedicated to another product line." Frances presented the following standard cost data for Hydro-Con valves: Raw material .................................... Purchased components .................... Direct labor ...................................... Manufacturing overhead ................. Total standard cost ........................... $35 30 12 44 $121 After distributing copies of the budgeted income statement for the upcoming fiscal year (Table A), Frances revealed the variable overhead for the 80,000 unit Hydro-Con budget was $2,400,000. Of the budgeted fixed manufacturing costs, $400,000 was discretionary, with the remainder committed to basic capacity charges. Variable "other operating expenses" totaled $4 per unit; a 10% distributor commission ($20 per unit) comprised the variable portion of selling and general administration expenses. The Controller further indicated that manufacturing adjustments represented production variances and scrap, which she expected to vary with the number of valves produced. At the budgeted volume level, fixed other operating expenses would add an average of $16 to unit cost. Basic service costs such a production control, engineering administration, and accounting totaling $880,000 were allocated to Hydro-Con; the remaining fixed other operating expenses were directly related to the product line and were discretionary in nature. As the discussion continued, Ralph reviewed next year's budget. Of the total fixed selling, general, and administrative expense, $160,000 was earmarked for future advertising space in several trade publications and an upcoming trade show. The remainder of the budget related to salaries and other firm commitments. The Hydro-Con budget was designed to fully recover all costs at the 80,000 unit production level. The other product line budgets also were designed to fully recover costs at budgeted volume levels, and all fixed costs were expected to remain unchanged until the current maximum capacities were surpassed (Table B). Jerry asked his Division Controller what effect the Wadsworth offer would have on profits. But Daria had not yet studied the effects volume changes would have on division operations. PRODUCT LINE ELIMINATION Superior Valve's Marketing Department prepared a sales order plan by product line for each new year in both units and dollars. The Production Control Department then used the order plan to develop a sales shipment plan for each of the division's three plants. Ralph Darwin had very little marketing information to use in developing the Made to Order (MTO) Hydraulic Control product line plan. However, he knew that the line's compound growth pattern over the last three years had been quite disappointing, and he saw little prospect for substantial sales growth in the short-term future. Ralph recommended the division consider eliminating the Made to Order line. Daria had assured him that the MTO-dedicated machinery could be retooled to produce either of the standard lines. Darwin was convinced he could develop a market for the additional standard product in a relatively short time, and he strongly believed the division should concentrate on its two basic product lines. "After all," he commented, "that's where we're most successful." However, until the additional market for the standard product was developed, the elimination of MTO would mean the elimination of 30 manufacturing jobs. At the last staff meeting of the year, Jerry Conrad told Ralph he would study the product line elimination proposal after he made a decision on the Hydro-Con special order. He assigned the proposal top priority for the New Year. TABLE A Superior Valve Division Budgeted Income Statement for the Year Ending 6/30/2009 ($000) Hydro-Con Revenue Material Direct Labor Overhead Total Cost of Sales @ Standard Gross Margin Adjustments Net Manufacturing Margin Other Oper. Exp. Expenses Selling & General Administration Operating Income Pneu-trol $16,000 5,200 960 3,520 9,680 6,320 800 5,520 1,600 1,920 $2,000 Made to Order $13,000 3,900 1,235 2,990 8,125 4,875 520 4,355 1,560 1,560 $1,235 $5,000 1,300 1,000 1,531 3,831 1,169 554 615 750 600 $(735 Total Division ) TABLE B Superior Valve Division Product Line Data Pneu-trol Unit selling price Variable overhead per unit Total discretionary fixed overhead Variable other operating cost per unit Variable selling and general admin. per unit Committed fixed other operating costs Committed fixed selling & general admin. $50.00 $6.50 $225,000 $1.50 $5.00 $970,000 $160,000 MTO $250.00 $50.55 $100,000 $5.00 $25.00 $550,000 $75,000 $34,000 10,400 3,195 8,041 21,636 12,364 1,874 10,490 3,910 4,080 $2,500 Product Line Hydro-Con Pneu-trol MTO Present Max. Capacity in Units Machine Hrs./Unit 100,000 350,000 50,000 6 2 5 REQUIRED: 1. Assume that inventories will not change during the year. Prepare budgeted contribution approach product line income statements for the year ending 6/30/2009. Categorize fixed costs as either discretionary or committed. 2. Should Jerry Conrad decide to accept the Wadsworth Company special order? If so, what will be the new Hydro-Con return on sales? 3. Should the Superior Valve Division eliminate the Made to Order product line if there were no alternative uses for its production capacity? 4. If all resulting standard products could be sold, how should the MTO capacity be allocated? (Assume only the capacity currently being used to produce 20,000 MTO units would be used to produce additional standard products.) 5. Identify the strategic factors that Superior Valve should consider. 6. What changes, if any, should be made to the division's cost system? Why