TENALPINA TOOLS:

PRODUCT LINE PROFITABILITY

Spazzatura! cried Giulia, crumpling the sheet of paper she had been scribbling on and throwing it against the wall.

Startled, Jeremy looked up from the bank reconciliation he was working on. Is something wrong? he asked. He received only a withering stare as a reply. Jeremy decided that his best course of action would be to return to his task.

Jeremy Rigby was, except for Giulia, the entire administrative staff at TenAlpina Tools. He had been hired 18 months earlier and so had been working for the company for almost half of its short life. In that time, he had never seen Giulia Ferrato so upset. After all, why should she be? Giulia had successfully introduced three product lines and, for such a small operation, the company was thriving. Just that morning he had given Giulia last months Monthly Income Statement (see Exhibit 1) and it sure looked pretty good from Jeremys perspective. Some additional background information appears in Exhibit 2.

The Product Lines

TenAlpina produced and sold rock climbing equipment. The business had begun with a single product, titanium pitons, produced by an outsource supplier. The titanium blades on these pitons made them lighter at a tensile strength equal to the competitors steel products. TenAlpina was selling over 50,000 of them each year to Giulias original and only piton customer. Before the first year of operation was over, Giulia had acquired the suppliers operation and introduced her second product, a titanium wall hammer. These lightweight,

This case was prepared by Alfred J. Nanni, Jr., Provost, Professor of Management Accounting, and Paul E. Juras, Chair of Accounting and Law Division, Professor of Management Accounting and Operational Performance, both of Babson College. It was developed as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. It is not intended to serve as an endorsement, source of primary data or illustration of effective or ineffective management.

BAB280/ MAY 2015

ergonomic-design wall hammers had met with great success, and the demand had surprised her. In recent months, hammer sales volume had leveled off at 400 units per month, more than 10% higher than Giulias ambitious expectations. About a year ago, Giulia had introduced her third product, rock nut sets.

A rock nut, also known as a stop or wedgie, is a small, wedge-shaped block of aluminum with a loop of braided steel cable threaded through it. A climber inserts the block of the rock nut into a small crevice and pulls on the cable loop from the small end, wedging the nut into the crevice. A line can then be attached to the loop using a carabiner. The set consisted of an assortment of six sizes. (See Exhibit 3.) Adding this product line required a minor change in the production flooran assembly work station with a power crimping tool and an assigned worker.

The Problem

The source of Giulias frustration was soon revealed to Jeremy when she had him call Granby Bolton into the office. Granby was the production supervisor. I feel like I must be missing something, Granby, or else somethings wrong with our product margins, Giulia began. I want you and Jeremy to help me talk through some conflicting data to see if we can unravel its source.

Arent we making money? Granby responded. I thought we were doing pretty well.

Overall, certainly, we are doing well, said Giulia. But I want us to be doing well on purpose, not by mistake! I initially targeted about a 34% gross margin, and we are close. Now I see demand for the wall hammer is quite strong, and I believe we could sell even more if we were to line up more distributors. However, demand has been disappointing for the rock nuts right from the start. I was expecting to sell about 3,000 sets per month when they were set at a price to hit our target margin, but demand has been closer to 2,300 per month, and thats after lowering the price to $24.50 per set. Even with the price drop, Im still getting pushback from our distributors. They say they just cant justify the price we charge when they can get equivalent ones from other manufacturers for less.

Jeremy asked whether competitors could be starting a price war on rock nuts, but Giulia countered that it wouldnt make much sense. There isnt a fortune to be made on that product, so I doubt anyone would want to price low intentionally unless they had a lot of unused capacity, she said. If they do have unused capacity, they may be pricing to cover variable costs. However, Im more worried about competitors simply being able to make them for less and still maintaining a good gross margin. Maybe they are more efficient than we are. If so, that could signal trouble for us in the future because rock nuts represent about 45% of our revenues.

Granby pointed out that he believed that the operation was pretty efficient at the current production levels. And that efficiency argument doesnt hold up for the hammers. You arent getting any complaints about price on them. In fact, you just said you think there is significant unmet demand. He paused for a moment and went on. Of course, if all we made was rock nuts, we could be getting by with less equipment and fewer people, but who is going to dedicate a whole factory to just rock nuts? All kidding aside, just how is each product doing?

Tenalpina Tools: Product Line Profitability

BAB280 / MAY 2015

Well, Granby, Giulia started, by my calculations, the pitons are doing a little over 35% gross margin, the rock nut sets are at about 32% after the $1.00 price cut. Hammers, unfortunately, show a gross margin of around 26%.

Giulia, you said that by your calculations, the margins were 35%, 32%, and 26%. What did you mean when you said by your calculations? Isnt there only one way to calculate gross margins? asked Jeremy.

Its not really the calculation of the margins that differs, its the calculation of the costs, Giulia replied.

Ive been using standard direct labor hours as a simple way to divide up labor and overhead costs among the three product lines. You may recall that shortly after you joined the company, we did some time measurements all over the shop to determine the average labor time at each station for each product when production was in full swing. If I sum up the total for each product, thats the standard labor time. Here are those times. You will also see that we performed a similar analysis for machine time, and those numbers are included as well. She handed Jeremy Exhibit 4.

When you supply me with the monthly volume totals for each product, she continued, I multiply each of those totals by the associated standard labor time. Then I add up those three numbers to get the total standard direct labor hours for the month. I then take all of the factory costs excluding direct materiallabor, depreciation, power, occupancy, and so on and divide that by the total standard direct labor hours to get a factory conversion cost per standard labor hour. Finally, I can use that rate to figure how much of the total goes to each product line by using the individual standard direct labor hour totals. I already have the volumes and prices and the direct materials costs, so at that point I can figure the gross margins in dollars and in percentage.

I dont know much about accounting, but it seems to me that some of our costs, like depreciation, variable power consumption, and supplies are really related to machine time, Granby responded. And the rock nuts use a lot less machine time than the pitons and hammers. Maybe thats the clue to the difference in costs our competitors seem to think they have.

I suppose we could try that out, Giulia said slowly. We already have the standard machine time, so I could separate the factory costs into two pilesdepreciation, variable power, and supplies to be allocated by standard machine hours, and labor, supervision, lighting, and occupancy to be allocated by standard direct labor hours.

Jeremy and Granby still seemed to be processing Giulias explanation when she perked up again. But you guys just gave me another idea! In my MBA program, we discussed activity- based costing. The idea is similar to Granbys point about some costs going with labor time and some going with machine time. The trick is to find the various cost drivers in the processthe measures of activity that have a direct logical association with the amount of resources that get used in the process. Maybe its just labor time and machine time like we just talked about, but maybe those two measures dont really reflect the underlying causes of resource consumption very well.

This document is authorized for use only by Carlos Garcia in Costs/Budgets - 2017 Fall taught by Lee, University of Houston - Victoria from August 2017 to February 20138.

For the exclusive use of C. Garcia, 2017.

Tenalpina Tools: Product Line Profitability

BAB280 / MAY 2015

The trio began talking about various processes in use in the factory and about ways to measure the work done in those processes. One of the first things they did was simply to enumerate the different possible production steps and the basic activity performed in each step. They decided the best way to classify activities was by work station. Granby produced a table (see Exhibit 5), showing the different work stations, the products that used them, and a measure of cost-driver activity for each station and for each product at that station.

By reviewing existing data, Jeremy was able to find direct measurements of some of the costs associated with each work station. Since each station had its own machines or tools, depreciation could be calculated for each station. Also, each station managed its own supplies, so directly tracing supply usage to the stations was quite easy. Similarly, each station had its own workers, allowing for the computation of total direct labor per station. Finally, each station had its own power meter for machine operation, meaning variable power could be determined directly, too.

There were still a few resources that were completely shared. How should we assign the cost of building occupancy and the fixed cost for lighting to the process activities? asked Jeremy. Granby suggested that both of those were space-related factors, so it made sense to associate them with the stations on the basis of square feet of floor space. As for the cost of my salary, he said, I spend roughly the same amount of time supervising each person on the floor, so I guess headcount would work for that.

Following this conversation, Jeremy produced the table in Exhibit 6. Upon handing it to Giulia, he commented, This last approach to calculating product costs seems a lot more complicated than the way you have been doing it or even the way Granby suggested. Do you think all the extra work is actually worth it?

I guess there is only one way to find out, Giulia replied. Lets try all three and see which one, if any, makes the most sense!

Monthly Income Statement for January

Product Sales Volume Pitons 4,200 Hammers 400 Rock nut sets 2300

Price/unit

$ 10.50 $ 61.00 $ 24.50

Cost/unit

$ 1.45 $ 10.44 $ 6.01

Revenue $44,100.00 $24,400.00 $56,350.00

Total DM $6,090.00

$4,176.00 $13,823.00

$2,855.00 $725.00 $ 1,612.92 $2,200.00 $5,270.83

$ 10,541.67

$ 600.00

$ 550.00

$ 745.00

% of sales

100%

Cost of Goods Sold Materials

Production Product volume

Pitons 4200 Hammers 400

$124,850.00

Rock nut sets Total DM

Direct Labor

Manufacturing Overhead

Light, Heat, and Power Supplies Depreciation Manufacturing occupancy Supervision

Total manufacturing overhead

Cost of Goods Sold

Gross Margin

S, G, and A Expense

Office salaries General administration Administrative occupancy Shipping and delivery

Operating Income for the Month

2300

$24,089.00 $47,916.67

$12,663.75 $84,669.42

$40,180.58

$12,436.67 $27,743.91

19.3% 38.4%

67.8% 32.2%

10% 22%

Work Stations

Labor Minutes

pitons hammers rock nut sets

Machine Minutes

pitons hammers rock nut sets

Exhibit 5: Work Stations, Activity Drivers, and Use by Product

Work stations:

pitons

hammers rock nut sets

Activity Driver

Activity counts:

pitons

hammers rock nut sets

* Pitons were packaged ten to a package for shipping to the distributor, who opened and repackaged them for customers. Hammers and rock nut sets were packaged in single units and one set per package, respectively.

Question:

Using standard direct labor time as the overhead allocation base, compute the gross margin for each product in order to verify Giulias belief about current gross margins.