Ten Alpina Tools: Product Line Expansion

Alfred Nanni, Paul Juras

Case Brief

Giulia Ferrato, a recent MBA graduate, has developed a high-quality piton, a tool used in mountain climbing. Owing to the security of a customers offer to guarantee a significant level of demand for a two-year period, she agreed to take over the forge needed for production. She is now trying to decide whether or not to introduce a new product line, a wall hammer. Some of the current capacity can be used to make this product, but its manufacture would incur some new costs. A move away from offering only a single product line also raises the issue of cost allocations.

Keywords: Multiproduct breakeven; Relevant costing; Accounting payback period; Cost allocation

Learning Objective

An entrepreneur has recently taken over a forge operation needed to produce the single product upon which the business was built. She has an idea for a new product line that can be manufactured using much of the currently available capacity. However, some new resources will also be needed and the movement toward becoming a multi-product company means the owner faces the need to allocate common production costs. The case asks students to analyze the financial effect of adding the new product line.

Learning Objectives

Introduce the concept of multiproduct product breakeven: Sales mix

Incremental costing on decision to add a product line: Relevant variable costs, Relevant fixed costs

Accounting payback period

Introduction of the need to allocate costs: Directly traceable, Common costs

Identify options for the resources contained in the business: Limitations and opportunities related to the cost structure

Assignment Questions

1. TenAlpina is adding a new product line, which will add some new costs as well. Based on Giulias estimates, and assuming that the volumes for piton production and sales do not change, how many wall hammers would TenAlpina Tools have to sell in order to have the same annual gross margin (in dollars) as it would have if only pitons were sold? That is, at what demand level for hammers would Guilia be indifferent (from a total profitability point of view) as to whether or not to add the new product line?
2. In question 1 you computed the number of hammers to sell to find a point of indifference for demand to decide whether or not to add the hammers. Now, using Giulias estimates and assumptions for both piton and hammer production and sales, what would be the total annual aggregate effect on total gross margin of adding the production and sales of the new wall hammer product line?
3. Given the uncertainty of demand, Giulia is concerned about the payback period for the investment in the new moulding machine. Using Giulias assumptions about demand, compute the payback period from an income and from a cash flow point of view. Be prepared to provide quantitative support for your answer.
4. Giulia wanted to look at financial risk another way, from a breakeven and margin of safety point of view. What is the breakeven point and margin of safety for TenAlpina? Assume the mix of 4200 pitons for every 350 hammers will remain fairly constant.
5. Now assuming the rock hammers have been added, and employing the estimates and assumptions provided in the case, what will be the unit gross margins for each of the two product lines?
6. Focusing on the pitons, how can you explain to Giulia the logic behind the results of your computations? That is explain the results in conceptual terms, not in terms of the computational mechanics.

TENALPINA TOOLS: PRODUCT LINE EXPANSION "Now comes the real test," Giulia thought to herself, "evaluating my idea for expanding the product offerings." She gathered up her notes and opened a blank spreadsheet file on her laptop. Just a few months ago, Giulia Ferrato's fledgling business, Ten Alpina Tools, was at a crossroads. The contract manufacturer of her only product, rock climbing pitons, wanted to sell his business and retire. Meanwhile, her customer wanted to quadruple purchase volume under an exclusive relationship. She had performed an initial analysis of the profitability of running the factory herself and found it less than reassuring. In the end, however, she felt that controlling the production facility was an opportunity she couldn't pass up. Now she wants to offer a new product line to take advantage of the underutilized capacity in hopes of improving the company's financial situation. The Beginning About a year ago, when Giulia returned from her internship between the first and second years of her MBA program, she began to research the potential to produce high-quality pitons from titanium. Pitons are like flat spikes, and rock climbers hammer them into crevices in the rock wall in order to attach support lines, making them a critical tool for the climbers. She was able to design a piton made of titanium that offered superior tensile strength while weighing significantly less than the standard steel alloy product. She also found a company that did drop-forging-an integral part of the production process-which had excess capacity and could produce the product in volumes Giulia believed she could sell. Her first order of 1,000 units evolved into a guarantee to purchase a volume of at least 4,000 units per month for the length of a two-year contract. At that same time, the owner of the company doing her manufacturing, a man named Stanley Kowalchek, offered to sell her his forge. Giulia initially worried that, if the business failed, she might be left with operating capacity for which there was little, if any, demand. However, she quickly realized that Kowalchek was already in that situation. Giulia recognized that she was in a position of strength in the negotiation. Exercising that leverage, she got Kowalchek to agree to sell her his business at the net book value of $86,130. At the sale date, that amount comprised only the plant equipment because there were no receivables, inventory, or intangible assets. Giulia's father had previously agreed to invest in her education, but in a non-traditional manner. He gave her the equivalent of the tuition she had spent on her recently completed 2-year MBA program to gain the practical education that would come from running a business. Adding that to her savings, she made the purchase and invested the remainder into the business. She kept the six experienced laborers on payroll at their existing pay rate and began production immediately. They needed no ramp-up time to learn the process since they already had experience making the pitons. She signed the exclusive arrangement with her customer, guaranteeing purchases of at least 48,000 pitons per year for two years. After a short shakedown period to familiarize herself with the operations and the administrative and record-keeping duties she had to perform, she refocused her attention on her new product idea-a titanium wall hammer. The New Product Rock climbers felt the major value provided by the titanium pitons were their performance and longevity, characteristics that matched the best steel alloy products, but at a superior light weight. Giulia expected that this comparative advantage would be even greater for the hammer, because current models often weighed close to 2 pounds. Competing wall hammers consisted of a steel head and a wooden or fiberglass handle. In contrast, Giulia's design was a "unitized" head and handle shaft (or haft). The titanium haft was very thin and yet stronger than the competition's handles. It was also quite lightweight, concentrating all of the weight in the head and enhancing performance for both driving and removing pitons. This thinness, however, created a design problem that Giulia saw as another opportunity. The handle needed to be thick enough to be comfortable in the climber's hand. Giulia designed a padded handle that not only provided appropriate grip-size ergonomics, but also isolated the climber's hand from the considerable shock generated when driving a metal spike into rock This padded handle could be most effectively provided through an injection-molded soft nylon-vinyl handle, bonded through the haft for secure hold. Refer to Exhibit 1 for an illustration of an example of a competitor's product. A New Machine Since Giulia's factory did not have an injection molding machine, she would need to acquire one. Her research found that she could buy and install the necessary equipment for $35,000. She found this machine would only have a seven-year life and added this information to the depreciation schedule (see Exhibit 2). There would be sufficient available floor space for an injection molding station in the factory once some of the existing equipment and racks were rearranged With the design specifications and the molding machine's operating characteristics in hand, Giulia felt she could estimate values for many of the remaining variables she needed to examine. First, she calculated the amount of titanium alloy and plastic resin each hammer would consume. At current input prices, the cost for volumes less than 10,000 per year would be $10.44 per unit. The engineering specifications on the molding machine indicated that it would consume significant amounts of electricity with each injection and cooling cycle. Based on the volume of material used in molding, she calculated each wall hammer would require a total of $0.46 of energy cost, including power for the other manufacturing steps. Without any better information, she assumed that the per unit supplies costs would be a little more for the hammers than for the pitons, and estimated the amount to be $0.14 per unit. She collected some data for current operations and projected costs, which appears in Exhibit 3. Estimating Price and Demand In the case of the pitons, her customer was the one who gave her the price and quantity. She did not want to be constrained by a similar relationship going into a new product line, so she tried to reverse-engineer those parameters from other information. After doing some online investigation and talking with several rock-climbing equipment retailers, she arrived at a target retail price of $94, the same price as a high-quality competitor. Reversing the markup her piton customer used (he was getting about a 35% gross margin), she determined that her price to retailers and distributors should be $61. Based on what she had been told by the retailers with whom she spoke, she decided that the hammers would generate a demand equal to about 350 units per month. Manufacturing Parameters Giulia sat down with her production team to discuss the effect on production of adding 350 hammers to the monthly production schedule. The experienced workers' analysis of the new work requirements based on the hammer's design revealed that it would require more labor effort per unit at each existing work station. Talking through the manufacturing process, they quickly determined that the current staffing level would be insufficient. The inadequacy of the resources was due in large part to the current work flow that had employees moving from station to station, thereby reducing available productive time. They decided that the installation of the new machine also provided an opportunity to rearrange the work flow by moving some of the existing equipment. The new machine and the redesigned work flow meant that they could easily handle the additional demand of 4,200 hammers a year with just two more laborers. In the new arrangement, there would be six work stations: 1. Roll/cut 2. Heat/forge 3. Bore (drilling) 4. De-burr and Polish 5. Injection Molding 6. Packing Under the proposed staffing plan, each of the six steps would have one permanently stationed employee except for the first two, which would have two each. Overall, given the total expected demand, they estimated that the hammers would consume 37% of the total productive labor time. (Giulia decided to use this percentage of direct labor time as the basis for allocating production costs other than materials to each product line in order to calculate product gross margins.) The work team told Giulia that she could simply follow tradition in filling the new two additional positions. She could hire the last two workers that had been laid off by Kowalchek a few months previously. The two would be ready to return to their old work arrangements (which included the same policies and wage rate paid to the current workers). Selling and Administrative Costs Giulia's current customer for the pitons was willing to absorb the cost of delivery, but she did not think this arrangement would hold for the hammers. She estimated shipping costs to be $1.00 per unit. She also felt that it might be time to start taking a modest salary. Giulia decided that a salary and benefits amount just 10% above that of the factory workers would be appropriate at this stage in the company's life, but she also wondered what kind of effect this would have on profits. "Before entering data into the blank spreadsheet," Giulia thought to herself, "I ought to spend some time trying to organize my thoughts. First, I want to know what to expect in terms of the overall profit effect of adding the hammer to my product line. How many hammers will I have to sell just to keep my annual profit the same as it is now? Also, is the investment in the new injection molding machine justified? What will the gross margin be on the new hammer? And will it affect the gross margin on the pitons? Exhibit 2: Depreciation Schedule, Including Estimate for Injection Molding Machine + Subtotal Machine type Cold roll and cut Oven & drop- forge Deburr and Bore Package Injection mold Total polish (making just pitons) Cost $29,000 $88,000 $15,000 $9,000 $2,550 $143,550 $35,000 $178,550 Life 10 10 10 10 10 7 $ 2,900 $ 8,800 $1,500 $ 900 $ 255 $ 14,355 $5,000 $ 19,355 Annual depreciation 4,200 units Exhibit 3: Current and Estimated cost and Revenue Data Current Results Average monthly piton demand Selling price per piton $10.50 Annual worker labor cost (fully-loaded, including benefits) $57,500 per worker Annual machine and tool depreciation (existing machines) $ 14.355 Annual occupancy cost (including building lease) $ 33,000 Annual lighting/heating/utilities cost $ 29,808 Direct material cost per piton Variable energy cost per piton $ 0.18 Variable supplies cost per piton $ 0.11 Annual administrative costs $ 7,200 Estimated Information Increase in fixed utility costs due to new machine $864 Material costs (per hammer) $10.44 Utility costs per hammer $0.46 Supply costs per hammer So.14 $ 1.45 Since Giulia had purchased the business, she had inherited both the net book value of the machines and their associated depreciation schedules. Thus, annual depreciation on existing equipment would remain at $14.355 per year