Polysar Limited As soon as Pierre Choquette received the September Report of Operations for NASA Rubber (Exhibits 1 and 2), he called Alf Devereux, Controller, and Ron Britton, Sales Manager, into his office to discuss the yeartodate results. Next week, he would make his presentation to the Board of Directors and the results for his division for the first nine months of the year were not as good as expected. Pierre knew that the NASA management team had performed well. Sales volume was up and feedstock costs were down resulting in a gross margin that was better than budget. Why did the bottom line look so bad? As the three men worked through the numbers, their discussion kept coming back to the fixed costs of the butyl rubber plant. Fixed costs were high. The plant had yet to reach capacity. The European Division had taken less output than projected. Still, Choquette felt that these factors were outside his control. His Division had performed welliit just didn't show in the profit results. Choquette knew that Henderson, his counterpart in Europe, did not face these problems. The European rubber profits would be compared to those of NASA. How would the Board react to the numbers he had to work with? He would need to educate them in his presentation, especially concerning the volume variance. He knew that many of the Board members would not understand what that number represented or that it was due in part to the actions of Henderson's group. Pierre Choquette, Alf Devereux, and Ron Britton decided to meet the next day to work on a strategy for the Board presentation. Structu re The operations of the company were structured into three groups: basic petrochemicals, rubber, and diversified products (Exhibit 3). Basic Petrochemicals Firman Bentley, 51, was Group ViceePresident of Basic Petrochemicals. This business unit produced primary petrochemicals such as ethylene as well as intermediate products such as propylene, butadiene, and styrene monomers. Group sales in 1985 were approximately $800 million of which $500 million was sold to outside customers and the remainder was sold as intermediate feedstock to Polysar's downstream operations. Rubber The Rubber Group was headed by Charles Ambridge, 61, Group VicerPresident. Polysar held 9% of the world synthetic rubber market (excluding communist bloc countries). As the largest Group in the company, Rubber Group produced 46% of Polysar sales. Major competitors included Goodyear, Bayer, Exxon, and Dupont. Rubber products, such as butyl and halobutyl, were sold primarily to manufacturers of automobile tires (six of the world's largest tire companies1 accounted for 70% of the world butyl and halobutyl demand); other uses included belting, footwear, adhesives, hose, seals, plastics modification, and chewing gum. The Rubber Group was split into two operating divisions that were managed as profit centers: NASA (North and South America) and EROW (Europe and rest of world). In addition to the two operating profit centers, the Rubber Group included a Global Marketing Department and a Research Division. The costs of these departments were not charged to the two operating profit centers, but instead were charged against Group profits. Diversified Products John Beaton, 48, was Vice-President of Diversified Products, a group that consisted of the Latex, Plastics, and Specialty Products Divisions. This group was composed of high technology product categories that were expected to double sales within five years. In 1985, the group provided 27% of Polysar's sales revenue. Bentley, Ambridge, and Beaton reported to Robert Dudley, 60, President and Chief Executive Officer. Rubber Group A key component of Polysar's strategy was to be a leader in high margin, specialty rubbers. The leading products in this category were the butyl and halobutyl rubbers. Attributes of butyl rubber include low permeability to gas and moisture, resistance to steam and weathering, high energy absorption, and chemical resistance. Butyl rubber was traditionally used in inner tubes and general purpose applications. Halobutyl rubber, a modified derivative, possesses the same attributes as regular butyl with additional properties that allow bonding to other materials. Thus, halobutyls were used extensively as liners and sidewalls in tubeless tires. Butyl and halobutyl rubber were manufactured from feedstocks such as crude oil, naphtha, butane, propane, and ethane (Exhibit 4). Polysar manufactured butyl rubbers at two locations: NASA Division's Sarnia plant and EROW Division's Antwerp plant. NASA Butyl Plant The original Sarnia plant, built in 1942, manufactured regular butyl until 1972. At that time, market studies predicted rapid growth in the demand for high-quality radial tires manufactured with halobutyl. Demand for regular butyl was predicted to remain steady since poor road conditions in many countries of the world necessitated the use of tires with inner tubes. In 1972, the Sarnia plant was converted to allow production of halobutyls as well as regular butyl. By the 1980s, demand for halobutyl had increased to the point that Polysar forecast capacity constraints. During 1983 and 1984, the company built a second plant at Sarnia, known as Sarnia 2, to produce regular butyl. The original plant, Sarnia 1, was then dedicated solely to the production of halobutyl. Sarnia 2, with a capital cost of $550 million, began full operations late in 1984. Its annual nameplate (i.e., design) production capacity for regular butyl was 95,000 tonnes. During 1985, the plant produced 65,000 tonnes. EROW Butyl Plant The EROW Division's butyl plant was located in Antwerp, Belgium. Built in 1964 as a regular butyl unit, the plant was modified in 1979/80 to allow it to produce halobutyl as well as regular butyl. The annual nameplate production capacity of the Antwerp plant was 90,000 tonnes. In 1985, as in previous years, the plant operated near or at its nameplate capacity. The Antwerp plant wasoperated to meet fully the halobutyl demand of EROW customers; the remainder of capacity was used to produce regular butyl. In 1981, the plant's output was 75% regular butyl and 25% halobutyl; by 1985, halobutyl represented 50% of the plant's production. Since regular butyl demand outpaced the plant's remaining capacity, EROW took its regular butyl shortfall from the Sarnia 2 plant; in 1985, 21,000 tonnes of regular butyl were shipped from NASA to EROW. Product Scheduling Although NASA served customers in North and South America and EROW serviced customers in Europe and the rest of the world, regular butyl could be shipped from either the Sarnia 2 or Antwerp plant. NASA shipped approximately onerthird of its regular butyl output to EROW. Also, customers located in distant locations could receive shipments from either plant due to certain cost or logistical advantages. For example, Antwerp sometimes shipped to Brazil and Sarnia sometimes shipped to the Far East, A Global Marketing Department worked with Regional Directors of Marketing and Regional Product Managers to coordinate product ows. Three sets of factors influenced these analyses. First, certain customers demanded products from a specific plant due to slight product differences resulting from the type of feedstock used and the plant configuration. Second, costs varied between Sarnia and Antwerp due to differences in variable costs (primarily feedstock and energy), shipping, and currency rates. Finally, inventory levels, production interruptions, and planned shutdowns were considered. In September and October of each year, NASA and EROW divisions prepared production estimates for the upcoming year. These estimates were based on estimated sales volumes and plant loadings (i.e., capacity utilization). Since the Antwerp plant operated at capacity, the planning exercise was largely for the benefit of the managers of the Sarnia 2 plant who needed to know how much regular butyl Antwerp would need from the Sarnia 2 plant. Product Costing and Transfer Prices Butyl rubbers were costed using standard rates for variable and fixed costs. Variable costs included feedstocks, chemicals, and energy. Standard variable cost per tonne of butyl was calculated by multiplying a standard utilization factor (i.e. the standard quantity of inputs used) by a standard price established for each unit of input. Since feedstock prices varied with worldwide market conditions and represented the largest component of costs, it was impossible to establish standard input prices that remained valid for extended periods. Therefore, the company reset feedstock standard costs each month to a price that reflected market prices. Chemical and energy standard costs were established annually, A purchase price variance (were input prices above or below standard prices?) and an efficiency variance (did production require more or less inputs than standard?) were calculated for variable costs each accounting period. Fixed costs comprised three categories of cost. Direct costs included direct labor, maintenance, chemicals required to keep the plant bubbling, and fixed utilities. Allocated cash costs included plant management, purchasing department costs, engineering, planning, and accounting, Allocated noncash costs represented primarily depreciation. Fixed costs were allocated to production based on a plant's \"demonstrated capacity\" using the following formula, Standard Fixed Estimated Annual Total Fixed Costs Cost Per Tonne Annual Demonstrated Plant Capacity To apply the formula, production estimates were established each fall for the upcoming year. Then, the amount of total fixed costs applicable to this level of production was estimated. The amount of total fixed cost to be allocated to each tonne of output was calculated by dividing total fixed cost by the plant's demonstrated capacity. Exhibit 5 reproduces a section of the Controller's Guide that defines demonstrated capacity. Each accounting period, two variances were calculated for fixed costs. The first was a spending variance calculated as the simple difference between actual total fixed costs and estimated total fixed costs. The second variance was a volume variance calculated using the formula: Volume : (Standard Fixed ) x ( Actual Tonnes ] _ [ Demonstrated ) Variance Cost Per Tonne Produced Capacity Product transfers between divisions for performance accounting purposes were made at standard full cost, representing, for each tonne, the sum of standard variable cost and standard fixed cost. Compensation Employees at Polysar had in the past been paid by fixed salary with little use of bonuses except at the executive level of the company. In 1984, a bonus system was instituted throughout the company to link pay with performance and strengthen the profit center orientation. Non-management employees The bonus system varied by employee group but was developed with the intention of paying salaries that were approximately five percent less than those paid by a reference group of 25 major Canadian manufacturing companies, To augment salaries, annual bonuses were awarded, in amounts up to 12% of salary, based on corporate and Divisional performance. Hourly workers could receive annual bonuses in similar proportions based on performance. All bonuses were based on achieving or exceeding budgeted profit targets, For salaried workers, for example, meeting the 1985 corporate profit objective would result in a 5% bonus,\" an additional $25 million in profits would provide an additional 4% bonus, Meeting and exceeding Division profit targets could provide an additional 3% bonus. Using periodic accounting information, Divisional VicePresidents met in quarterly communication meetings with salaried and wage employees to discuss divisional and corporate performance levels. Management For managers, the percent of remuneration received through annual bonuses was greater than 12% and increased with responsibility levels. The bonuses of top Division management in 1985 were calculated by a formula that awarded 50% of bonus potential to meeting and exceeding Divisional profit targets and 50% to meeting or exceeding corporate profit targets. Exhibit 1 NASA RUBBER DIVISION-Regular Butyl Rubber-Statistics and Analyses, September 1986 Nine Months Ended September 30, 1986 Actua Budget Deviation Volume-Tonnes ('000s '000s) ('000s) Sales 35.8 33.0 2.8 Production 47.5 55.0 - 7.5 Transfers to EROW 12.2 19.5 -7.3 from EROW 2.1 10 1.1 Production C ($'000s) ($'000s) ($'000s) Fixed Cost-Direct - 21,466 21,900 434 -Allocated Cash - 7,036 - 7, 125 89 ocated N 15,625 - 15,600 25 Fixed Cost to Production - 44, 127 - 44,625 498 Transfers to/from FG Inventory 1, 120 2,450 - 1,330 Transfers to EROW 8,540 13,650 5,1 10 Transfers from EROW 1,302 620 682 Fixed Cost of Sales 35,769 -29, 145 6,624 Note: As indicated on p.1 of the case, financial data have been disguised and do not represent the true financial results of the company.Exhibit 2 NASA RUBBER DIVISIONRegular Butyl RubberStatement of Net Contribution, September 1986 Sales RevenueThird Party Diversified Products Group Total Delivery Cost Net Sales Revenue Variable Costs Standard Cost Adjustments Efficiency Variance Total Gross Margin$ Fixed Costs Standard Cost Adjustments Spending Variance Volume Variance Total Gross Profit$ % of NSFi Period Costs Administration, Selling, Distribution Technical Service Other Income/Expense Total Business Contribution Interest on Working Capital Net Contribution Nine Months Ended September 30, 1986 Actual Budget Deviation $ '0005 $ '0005 $ '0005 65,872 61,050 4,822 160 210 - 50 66,032 61,260 4,722 2,793 2,600 193 63,239 58,660 4,579 -22,589 -21,450 -1,139 54 54 241 241 -22,294 -21,450 - 844 40,945 37,210 3,735 25,060 23,100 1,960 168 80 88 498 - 498 -11,375 - 6,125 -5,250 -35,769 -29,145 -6,624 5,176 8,065 -2,889 8.2% 13.7% -5.5% - 4,163 - 4,000 - 163 - 222 - 210 - 12 208 50 158 4,177 4,160 17 999 3,905 2,906 1,875 1,900 25 876 2,005 -2,881 Note: As indicated on p.1 of the case, financial data have been disguised and do not represent the true financial results of the company. Exhibit 6 Schedule of Regular Butyl Shipments from NASA to EROW Actual Tonnes Budget Tonnes 1985 21, 710 23,500 1984 12.83 13,700 1983 1,432 4.000 1982 792 600 1981 1,069 700 Exhibit 7 EROW RUBBER DIVISION-Regular Butyl Rubber-Condensed Statement of Net Contribution, September 1986 Nine Months Ended September 30, 1986 Sales Volume-Tonnes 47,850 ($'000s) Sales Revenue Delivery 94,504 Cost 4.584 Net Sales Revenue 89,920 Variable Cost Standard -28,662 Purchase Price Variance 203 entory Revaluation 46 Efficiency Variance 32 Total 28,473 Gross Margin-$ 61,447 Fixed Cost to Production Depreciation - 4,900 Other .16,390 21,290 Transfers to/from F. G. Inventory 775 Transfers to/from NASA : 7.238 - 9,303 Gross Profit-$ Period 32, 144 Costs Business - 7.560 Contribution Interest on 24,584 W/C 1,923 Net Contribution 22,661