Superior Manufacturing Company In February 2005, Herbert Waters was appointed general manager of the Superior Manufacturing Company by Paul Harvey, president. Waters, 56, had wide executive experience in manufacturing products similar to those of Superior. The appointment of Waters resulted from management problems arising from the death of Richard Harvey, founder and, until his death in early 2004, president of Superior. Paul Harvey had only four years' experience with the company, and in early 2005 was 34 years old. His father had hoped to train him over a 10-year period, but his untimely death had cut this seasoning period short. The younger Harvey became president when his father died and had exercised full control until he hired Waters. New Management Paul Harvey knew that during 2004 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 2004 (see Exhibit 1) showing a net loss of $688,000 during a good business year, he knew he needed help. He attracted Waters from a competitor by offering a stock option incentive in addition to salary, knowing that Waters wanted to acquire a financial competence for his retirement. The two men came to a clear understanding that Waters, as general manager, had full authority to execute any changes he desired. In addition, Waters would explain the reasons for his decisions to Harvey and thereby train him for successful leadership upon Waters's retirement Upon taking office in February 2005, Waters decided against immediate major changes. Rather, he chose to analyze 2004 operations and to wait to see results for the first half of 2005. He instructed the accounting department to provide detailed expenses and earnings statements by products and departments for 2004 (see Exhibit 2). In addition, he requested an explanation of the nature of the company's costs including their expected future behavior (see Exhibit 3). Company and Industry The Superior Manufacturing Company made only three industrial products: 101, 102, and 103. They were sold by the company's sales force for use in the processes of other manufacturers. All of the sales force, on a salary basis, sold the three products but in varying proportions, Superior sold throughout New England and was one of eight companies with similar products. Several of its competitors were larger and manufactured a larger variety of products than did Superior. The dominant company was the Samra Company, which operated a branch plant in the company's market area. Customarily, the Samra Company announced prices annually, and the other producers followed suit. 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 the Samra 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, Waters was convinced Superior could not individually raise prices without suffering substantial volume declines. During 2004, Superior's share of industry sales was 12% for type 101,8% for 102 and 10% for 103. The industrywide quoted selling prices were $24.50, $25.80, and $27.50 per 100 pounds of product, respectively Manufacturing Strategy Superior's manufacturing strategy was based on the "dedicated factory" concept. That is, each of the three products was produced in its own factory within the total factory complex. The three product factories were referred to as 101 Factory, 102 Factory, and 103 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, the Superior manufacturing facilities operated below capacity. Cost System The Superior 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. Management's goal was to assign all of the company's costs to each of the three products in a way that would lead to the most useful product costs for the cost system's 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 to 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 the three products was sold in 100-pound bags, per unit costs were expressed in terms of 100 pounds of finished product. The per unit cost was calculated by dividing the unit output into the respective product factory's total cost. Total cost was the sum of the product factory's direct costs plus allocated indirect costs less an allocated other-income amount. Allocated indirect costs included the company's interest cost related to bank loans. Costs designated 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 101 in 101 Factory was charged directly to the 101 Factory account. This material cost could be traced directly to 101 Factory through material purchase and requisition orders. Indirect costs were allocated to the product factories using a variety of allocation methods (see Exhibit 2). 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. Figure A Total Company Rent ($5,324,000) Actual Rent Expense Allocation Basis (cubic space) Allocated Rent 101 Factory ($1,872,000) 102 Factory ($1,570,000) 103 Factory ($1,882,000) Source: Casewriter The allocated per 100-pound rent cost of each product was derived by dividing the unit output of each product factory into the respective product factory's allocated rent. A standard cost system was introduced in early 2005. It was used to value inventories, prepare budgets, and analyze performance (see Exhibit 4). Next year's standard costs were last year's actual per unit costs adjusted for anticipated cost changes. Since Superior's three products were each sold in 100-pound bags, per unit standards were expressed in terms of 100 pounds of finished product. Drop 103? To familiarize Paul Harvey with his methods, Waters sent copies of Exhibits 2 and 3 to Harvey, and they discussed them. Harvey stated that he thought product 103 should be dropped immediately, as it would be impossible to lower expenses on product 103 as much as $2.16 per 100 pounds. In addition, he stressed the need for economies on product 102. Waters relied on the authority arrangement Harvey had agreed to earlier and continued production of the three products. Midyear Results In the first week of July 2005, Waters 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 2005 had been a successful period. In order to expedite the availability of interim-period results, Superior 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 101 Price? During the latter half of 2005, the sales of the entire industry weakened. Even though Superior retained its share of the market, its profit for the last six months was expected to be small. In November 2005, the Samra Company announced a price reduction as of January 1, 2006 on product 101 from $24.50 to $22.50 per 100 pounds. This created a pricing problem for all its competitors. Waters forecast that if Superior held to the $24.50 price during the first six months of 2006, the company's unit sales would be 750,000. He felt that if it dropped its price to $22.50, the six months' unit volume would be 1 million. Waters knew that competing managements 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 2006, with two exceptions: materials and supplies would be about 5% below the 2005 standard. Waters and Harvey discussed the pricing problem. Harvey observed that even with the anticipated decline in material and supply costs, a sales price of $22.50 would be below cost. Harvey 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. Questions 1. Based on the 2004 statement of profit and loss data (Exhibits 1 and 2), do you agree with Waters's decision to keep product 1032 2. Should Superior lower as of January 1, 2006 its price of product 101? To what price? 3. Why did Superior improve profitability during the period January 1 to June 30, 2005? How useful was the data in Exhibit 4 for the purpose of this analysis? 4. Why is it important that Superior has an effective cost system? What is your overall appraisal of the company's cost system and its use in reports to management? List the strengths and weaknesses of this system and its related reports for the purposes management uses the system's output. What recommendations, if any, would you make to Waters regarding the company's cost accounting system and its related reports? Exhibit 1 Profit and Loss Statement for Year Ending December 31, 2004 (000) $105,905 1.567 $104,338 65.251 $ 39,087 Gross Sales Cash Discount Net Sales Cost of Manufacturing Manufacturing Profit Less: Seling Expense General Administration Depreciation Operating Profit Other Income Net Profit before Interest Less: Interest Net Loss $18,383 6,534 13.591 38,508 $ 579 205 $ 784 1.472 $ 688 Source: Casewriter. Exhibit 2 Analysis of Profit and Loss by Products and DepartmentsYear Ended December 31, 2004 (thousands $ except per 100 lbs.) Product 101 per 100 lbs. Product 102 per 100 lbs. Product 103 per 100 lbs. Total Classification Direct Indirect Allocation Basis Rent $ 1.90 $5,324 $ 1.872 621 524 $.88 29 $1,570 503 $1.53 49 $ 1,882 401 .40 X 1,525 1,463 Cubic space Area Value of equipment Direct labor (8) 25 405 39 534 .53 836 39 439 .42 458 .46 6.06 5.92 6,879 6.97 2.07 6,107 2.124 251 2.06 2.309 2.33 24 302 31 12.937 4,413 220 158 109 7.641 525 Direct labor (S) Machine horsepower Area 130 .12 .10 .11 .07 .05 3.59 1.733 25,921 8,846 773 394 266 17,208 1,360 438 106 75 .08 Area 82 4,716 .08 4.91 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 4.58 25 485 .46 4,851 350 104 36 184 0B -15 .10 150 $16.962 $30.040 $14.09 $18,249 $18.45 $ 65,251 $16.44 4.44 4.27 4,582 4,701 4.76 18,383 1.62 1.300 1.26 1,783 X 1.80 3.70 2.65 S value of sales $value of sales Value of equipment Value of equipment 3.658 9.100 3.451 5,659 524 $48.774 101 $48.673 4.16 .39 25 539 .53 6,534 13,591 1,472 $105,231 205 4.274 409 $27,527 53 $22.88 .04 $26.69 .05 $26.64 $28,930 51 $29.24 .05 $value of sales $22.84 $27,474 $28,879 51,672 24.24 26,670 25 23 ($ 1.41) $29.19 27.03 ($ 2.16) $105.026 104,338 ($ 688) $ 2,999 $ 1.40 Sales (Net) Profit (Loss) Unit Sales (100 lbs.) Quoted Selling Price Per Unit Cash Discount Taken (% of selling price) 25.996 ($ 1,478) 1,029,654 $25.80 2.132.191 $24.50 ($2.209) 986.974 $27.50 1.08% 2.14% 1.74% 1.48% Source: Note: Casewriter. Figures may not add exactly because rounding 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. Purchases 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 nonvariable. They can be changed, of course, by management decision. Cash Discount: Almost nonvariable. Average cash discounts taken are consistent from year to year. Percentages in Exhibit 2 are accurate, Light and Heat: Almost nonvariable. Heat varies slightly with fuel cost changes. Light a fixed item regardless of level of production. Property Taxes: Almost nonvariable. 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: Nonvariable. Lease has 12 years to run. Building Service: Nonvariable. At normal business level, variances are small. Property Insurance: Nonvariable. Three-year policy with fixed premium. Depreciation: Nonvariable. Fixed dollar total. Exhibit 4 Profit and Loss by Products and Departments at Standard and Total Company Variances from January 1 to June 30, 2005 (thousands $ except per 100 lbs.) Product 101 Standard Total at per 100 lbs. Standard Product 102 Standard Total at per 100 lbs. Standard Product 103 Standard Total at per 100 lbs. Standard Total Standard Total Actual Variances + = Favorable - Unfavorable Item $ 2,919 839 $ 2,660 770 Rent Property Tax Property Insurance Compensation Insurance Direct Labor Indirect Labor Power $.88 29 25 .39 $ 877 289 249 389 +259 +69 +61 $ 1.53 .49 39 .42 5.92 2.06 24 $ 1.90 .40 .53 .46 732 917 $ 1,090 349 278 299 4,216 1,467 171 85 $ 952 201 266 231 3.496 1,168 155 50 +2 -69 6.06 6.97 793 919 13,751 4.698 435 205 +213 6,041 2,063 109 70 2.07 .11 .07 .05 2.33 .31 13,820 4.485 432 200 107 9.282 +3 +5 .12 .10 50 .08 57 .08 40 147 +40 3.59 4.58 4.91 2.461 9,301 +19 3,579 239 .46 .36 180 747 750 -3 25 .08 .15 .10 251 Light & Heat Building Service Materials Supplies Repairs Total Selling Expense General Administrative Depreciation Interest Total Cost Less: Other Income $ 16.44 4.44 236 $34.990 9,805 - 15 +584 -25 $14.09 4.27 1.62 2.65 50 $ 9.248 2,386 902 3.261 328 107 $ 11,708 3.162 897 2,962 278 $ 19,007 36 79 $14,034 4.257 1.615 2.642 249 $22,797 40 $18.45 4.76 1.80 3.70 1.26 4.16 3.414 7.459 793 $34,406 9,830 3.289 6,817 730 $55,072 +125 +642 25 .39 .53 1,855 266 $14,657 25 $22.88 $ 26.69 $29.24 +63 +1,389 +9 .04 .05 .05 110 $22.84 +1.398 $ 26.64 25.23 $22,757 24.164 $ 1,407 $14,632 13,550 Actual Sales (net) Profit (Loss) Unit Sales (100 lbs.) $56,461 101 $56,360 55,675 ($ 685) $ 18,971 17.961 ($1,010) 24 24 $ 1.40 $29.19 27.03 ($ 2.16) 501,276 $54,962 55,675 $ 713 ($1,082) +1,398 ($ 1.41) 712,102 996,859 Source: Case writer. "Actual unit sales times standard net revenue per unit. Instructions for the Superior Mfg case In your case memo answer question 2 from the Superior Manufacturing Company case using the additional data and other specific instructions below. Herbert Waters wanted a more detailed understanding of the company's pricing options for product 101, so he commissioned a brand new sales forecast to use in considering the product 101 price. In your response to question 2, use the prices and estimated sales quantities provided in Table 1 in place of the sales quantities estimated in the paragraph immediately under "Reduce 101 Price?" in the case study. The extended sales forecast assumes competitors do not match the price cut at $22.00 but rather follow Samra Corp. and price at $22.50 Table 1: Expanded sales forecasts Price Sales forecast $24.50 750,000 $24.00 812.500 $23.50 875,000 $23.00 900,000 $22.50 1,000,000 $22.00 1,125,000 Waters asks you to do your analysis two ways: (A) using table 1 as presented which assumes the competition prices at $22.50, and (), assuming competitors match the price cut to $22.00. this second case, assume sales at $22.00 will be 1,000,000 Your memo should consist of the memo header as usual, then exactly two paragraphs of recommendations/explanations, and additional tables or figures if such additions help your explain your recommendations. . In the first paragraph offer a recommendation using assumption (A) above and provide enough explanation to convey a sense of your analysis and how it supports your recommendation, in the second paragraph offer a recommendation using assumption (B) above and provide enough explanation to convey a sense of your analysis and how it supports your recommendation, In your memo, be as clear as you on your recommendations and on how the results of your analysis back up your recommendations. A key here is, of course, identifying the relevant costs. Not all of the costs presented will vary with changes in output, so your challenge is to figure out just how to sort through the costs to decide which are relevant to the question to be answered. Note that the classification of costs into "Direct" and "Indirect" is helpful but not everything. Consider the information offered in Exhibit 3 in the case and how it relates to the question of relevant costs