SOUTH DAKOTA MICROBREWERY1 In 1992, two former Anheuser-Busch employees started their own brewery, South Dakota Microbrewery (SDM). Sandy Bennett and Dave Goldstone developed a business plan and obtained a Business Start-up Loan from a local commercial bank. The loan proceeds, combined with their own savings were sufficient capital to purchase a small manufacturing facility and equipment. To save money, they purchased most of the stainless steel equipment at a dairy farm auction and then converted the equipment to suit their needs. Other supplies and equipment were purchased from a brewers supply house in Wisconsin. As of December 1997, South Dakota Microbrewery has grown steadily and now produces three labels of specialty beers. The company posted its first profit in December 1995. The Brewing Process Brewing is essentially a four-stage process, as shown in Exhibit 1. Direct labor is incurred primarily in stages one, two and four. The first stage requires mixing malt, sugar, hops, and water and cooking the mixture. At this point the mixture is referred to as wort. SDM uses a 350 liter copper kettle with a natural gas burner for this part of the process. Preparing wort takes 4 to 7 hours, depending on the particular brew produced. The second stage of the brewing process requires siphoning the wort through a wort chiller into one of eight fermentation tanks owned by SDM. The wort chiller is a double copper tube in which cold water is forced one direction in the outer tube and the wort is pumped the other direction (into the fermentation tank) through the inner tube. This action is required to chill the wort as rapidly as possible from boiling temperature to approximately 21C or 70F. Rapid chilling is necessary to minimize the possibility of contamination and bacterial growth in the wort. This stage of the process takes about one-half hour per batch, as the chiller can process about 10 liters per minute. Fermentation is the third step in brewing. Brewers yeast is added after the wort has been properly chilled and collected in the fermentation tank. The tank is then sealed and a fermentation lock is placed on the tank. Yeast, malt and sugar combine to form two products: carbon dioxide and alcohol. The carbon dioxide is allowed to escape through the fermentation lock that prevents air from entering the tank. The fermentation process takes from 3 to 14 days, again depending on the product being brewed. Several samples are taken from the brew during the fermentation process. Some samples are taken for taste testing. Others are used to determine the status of the fermentation process using a hydrometer. After this first fermentation is completed, flat beer has been produced. Thus, the final stage of the brewing process consists of carbonating the brew and siphoning it from the fermentation tank through a filter into bottles. The filter is used to prevent wild yeast from entering the bottles and to help the beer clear properly. Wild yeast can result in bacterial growth and cause the beer to have a cloudy appearance. SDM utilizes the injection method of carbonation. Essentially, CO2 is injected into the bottle simultaneously with the beer. The bottles are then capped, labeled and put into cool storage for several days. After three to five days of aging, the brew is ready to be sold and delivered to the local pubs that sell South Dakota beer. South Dakota Microbrewery produces three different types of beer: Buffalo Ale, Four Heads Stout and Bismark Bock. Buffalo Ale is a medium-colored amber ale with a slightly sweet taste. SDMs Four Heads Stout is similar to the rich, bitter stouts from well-known Irish breweries. For both of these brews, the production process is fairly straightforward. By contrast, Bismark Bock requires more attention in order to obtain the thick, rich, full-flavored aromatic taste characteristic of bock beers. The ale was sold primarily to bars in college towns that ordered large shipments. SDM is planning to brew 250 batches of ale in the 1998 fiscal year. The stout and bock beers were more specialty- type products that were shipped to upscale restaurants and hotels that ordered smaller quantities. Consequently, SDM plans to brew 120 batches of both their stout and their bock beers. Distribution logistics was an important factor in maintaining a stable customer base and opening up new opportunities for SDM. After covering all of their manufacturing costs and distribution costs, Sandy and Dave split the remaining profits after paying their interest costs, taxes and setting aside a reasonable amount to fund unforeseen expenses. Company Prospects Between them, Sandy and Dave have 15 years of experience in the brewing industry. However, neither was experienced in management until they formed SDM. Local competition has been intense, causing some beer prices to fluctuate substantially. Ale prices have been falling throughout the market and SDM has followed recently with price declines over the last year. However, SDM recently raised its bock beer price 10% with no apparent market response to the price increase. Sandy attributed this to steady demand and no local competition for this particular product offering. She was concerned, however, that ale prices had fallen such that the ale's gross margin had eroded far below the targeted 30% that she and Dave had established as a goal for each brew label. Sandy was concerned that extended sales of Buffalo Ale at low margins would cause SDMs profitability to decline. Currently, SDM was charging $1.05 per 18-oz. bottle for Buffalo Ale, $1.50 for Bismark Bock and $1.40 for Four Heads Stout. Sandy and Dave mentioned their concerns about the Buffalo Ales declining gross margin to the companys accountant, Tom Hawkins. After some discussion, Tom suggested that the current plant-wide method of allocating indirect costs might not be the best method to use when different products utilize productive resources to varying degrees. It was agreed that Tom would investigate alternative costing approaches that could lead potentially to different pricing and marketing decisions. Specifically, Tom mentioned that SDM could probably benefit from using a cost accounting system that more directly traces overhead costs of production for each label. Cost Analysis After spending some time with Sandy and Dave as well as in the plant, Tom broke down estimated total annual overhead costs into eight different activities based on last years records and anticipated cost increases, as shown in Exhibit 2. Also shown in Exhibit 2 are the cost drivers that Tom determined were associated with each activity. Exhibit 3 contains Toms estimated total volume for each cost driver for the coming fiscal year (Panel A) and broken down by product (Panel B). Tom noted that depreciation and storage are primarily fixed costs, while the maintenance & sterilization cost is half-variable and half-fixed. The remaining cost pools are substantially variable in nature. Tom then started to compile the direct product costs associated with Buffalo Ale, Bismark Bock and Four Heads Stout. His analysis thus far is presented in Exhibit 3. Tom was still uncertain whether the plant-wide allocation of overhead based on direct labor-hours was appropriate. He wanted to compare this approach to activity-based cost (ABC) systems he had seen implemented in other firms. Once this analysis was completed, he should be able to assist Sandy and Dave with pricing decisions regarding their three beer labels.

Objective

Provide the best recommendations for strategy to Sandy and Dave regarding their labels and provide support regarding pricing, costing, and any other areas. Keep in mind who South Dakota wants to be as a microbrewer and where the founders came from.

Exhibit 2. Budgeted overhead Costs for the 1996/1997 Fiscal Year Activity Estimated Cost Cost Driver Maintenance & Stcrilization $30,000 Fcnmentation Days Mixing & Cooking 8.000 Fermentation Days Chilling & Siphoning 7,500 Direct Labor Hours Equipment Depreciation 5,500 Machine Hours Quality Control 10,500 Number of Quality Control Inspections Bottling & Labeling 21,000 Number of Bottles Storage 3,000 Number of Bottles Shi 31.250 Number of Orders Total $116,750 Exhibit 3. Estimated Activitics for the 1996/1997 Fiscal Year Panel A: Estimated Annual Volume Cost Drivers Total Fermentation Days 2,910 Direct Labor Hours 7.500 Machinc Hours 82.700 Number of Orders 3,740 Number of Quality Control Inspections 4,850 Number of Bottles Produced 229,920 A fermentation-day is one 24-hour period in which wort occupies a fermnentation tank. South Dukota Microbrewery owns eight fermentation tanks. Thus, eight tanks occupied 365 days per year results in 2,910 F-Ds, when time is allowed for cleaning (about 1 houritankiyear). There arc 24 bottles to one case. Panel B: Estimated Requirements per Batch by Beer Label Bismark Four Cost Drivers Buffalo Ale Bock Heads Stout Fermentation Days 14 Direct Labor Hours 18 12 13 Machine Hours 10 325 135 Number of Orders Number of Quality Control Inspections 22 Number of Bottles per Batch 528 38 432