Using the controller's projections, create an analysis of the expected effect of outsourcing the product on Patterson's profitability.

IMA The Association of EDUCATIONAL Case Accountants and Case Journal Study ima Financial Professionals in Business ISSN 1940-204X Patterson Manufacturing Shane Moriarity Andrew Slessor University of Oklahoma and Unitec New Zealand Unitec New Zealand INTRODUCTION was the primary donor for the construction of the municipal library and the local hospital. And the taxes paid by the firm The vice president at your company, Columbia Holdings, has and its employees are responsible for an excellent array of given you a new assignment: "Recently I asked the folks at community services, including the Patterson Sports Complex Patterson Manufacturing to develop a strategy for improving and Patterson Community Center. their profitability. They have responded with a proposal. I want The Great Depression in the 1930s brought hard times you to evaluate the proposal: Is it viable? Is it sustainable? Visit to the company, yet none of its employees were discharged. their operations and bring back a recommendation." Instead, the firm and its employees cooperated to spread As you travel to the site you review a brief history of the available work among its employees by reducing each the firm. Patterson Manufacturing was founded in a small individual's working hours (and wages). During that time, northeastern city more than a century ago. Wesley Patterson the firm also suspended paying dividends to its owners. started the firm alongside a fast-moving stream that provided After the company returned to prosperity in the 1940s, it mechanical power to drive cutting tools, grinders, lathes, and continued to emphasize customer-driven creative solutions, polishers. These tools were used to produce precision parts and its loyal workforce enthusiastically overcame product other manufacturers needed. The firm quickly established design challenges. a reputation for producing high-quality products to exacting Wesley passed leadership of his business to his son, tolerances. The firm prospered. who later passed it down to Wesley's grandson, and then to Wesley studied the industries he served to develop new Wesley's great granddaughter, Jessica Patterson. But five products that could fill his customers' emerging needs. He years ago, when Jessica wanted to retire, there was no heir often met with customers to design unique products for willing to take over the business. Consequently, the plant them. He referred to his approach as providing "customer- was sold to your employer, Columbia Holdings. driven creative solutions." He also kept abreast of new manufacturing materials and technology to ensure his BACKGROUND products were of the highest quality. The firm grew steadily and, by 1925, was (and still is) the Columbia invests in family-owned businesses with a strong community's largest employer. Wesley donated the land that presence in niche markets. Columbia retains existing is now the city's central park. He also paid for constructing management and local business practices but provides the first municipal buildings. More recently, the company centralized services, such as finance, accounting, insurance, IMA EDUCATIONAL CASE JOURNAL 1 VOL. 6, NO. 4, ART. 1, DECEMBER 2013and corporate-level management. Patterson has remained He also said, "By outsourcing the Gudgeon EH40, we can profitable since the acquisition, but its return on investment release three administrative managers, eight administrative has been declining. support staff, 128 general production personnel, and 10 supervisors. Your first stop at the Patterson complex is a meeting with The firm will incur a one-time charge of $1 million for severance the controller. He provides some additional background: pay and pension contributions for dismissed employees. We'll 'Jessica, like her predecessors, spent most of her time with also need to spend $200,000 for the construction of receiving customers developing new products to meet customer needs. facilities for the outsourced product." She didn't concern herself with costs. Customers were willing The controller continued: "The supplier's cost quotation to pay for products that solved problems. Upon Jessica's (Exhibit 4) needs to be adjusted for the expected 15% retirement, Columbia appointed Paul, our former production increase in volume. The cost for materials and labor will manager, to CEO. Paul has done wonders in rationalizing and increase proportionately, but the overhead and 'other' costs standardizing our product lines. He substantially reduced are unlikely to be affected. The supplier's mark-up will be manufacturing costs, which led to record profits in the two 10% of the new total cost. In addition to the product cost, years following the sale of the company. Those early results Patterson will incur transportation costs to get the product have apparently set high expectations for our continuing from the manufacturer to our warehouse. The transportation performance. Our proposal will help move us toward meeting costs are variable and would have been $0.6 million for the those expectations," he said. volume of product in Year 5." "Our proposal is to stop manufacturing our largest-selling product, the Gudgeon EH40, and instead acquire it from an THE TASK overseas supplier," continued the controller. "This product currently represents 30% of our total sales revenue and After his brief overview, the controller hands you the exhibits production volume. But sales have been declining because and says, "You should go through the numbers yourself to competitors are offering a similar product at lower prices. We ensure that my projection for the increase in profit is correct." think that by reducing our price by 5% we can increase our As you make your way to an empty office to review the unit sales volume by 15%. The increased volume coupled numbers, the marketing manager approaches you. She pleads, with a lower product cost from the offshore supplier should "Don't let them do this. The proposed action will deal a nearly double our firm-wide profit." devastating financial blow to our community. Wesley Patterson The controller also provided some supporting would have never approved such a move. He loved this town." documents. Exhibit 1 summarizes operations for the five years since Patterson Manufacturing was sold to Columbia REQUIRED Holdings. Year 1 represents the first full year after Jessica Using the controller's projections, prepare an analysis retired, and Year 5 is the year that just past. Exhibits 2, 3, of the expected effect of outsourcing the product on and 4 provide an income statement for Year 5, the current Patterson's profitability. employee staffing levels by job title, and a detailed price 2. Would it be a viable alternative to produce the product proposal from the overseas supplier. locally and lower the price to achieve the increase in sales The controller continued: "The analysis is pretty volume? straightforward. Sales of the Gudgeon EH40 were $27 3. Does the firm have an obligation to maintain million last year. The direct material costs came to $14.3 employment levels in the town? million, while overhead costs of $4.2 million were allocated 4. What risks are associated with the proposal? to the product. But only $2.9 million of the overhead will be 5. Make a recommendation to your vice president on avoided if we stop manufacturing the Gudgeon EH40. The whether the proposal should be accepted. Provide remaining overhead costs are nearly all fixed and not subject your reasoning and any suggestions for additional or to reduction in the near future. Our direct selling costs consist alternative actions that Patterson should take. mostly of an 8% commission paid to sales representatives. In addition, there's a $2 million advertising allowance devoted to promoting the Gudgeon EH40 in trade magazines." IMA EDUCATIONAL CASE JOURNAL 2 VOL. 6, NO. 4, ART. 1, DECEMBER 2013Exhibit 1: Patterson Manufacturing Five-Year Summary of Operations Year 5 Year 4 Year 3 Year 2 Year 1 Total Revenues $90.2 $94.9 599.1 $106.2 $111.4 Net Income $3.1 $3.8 $4. $7.3 $7.5 Domestic Sales $74 7 $76.9 $79.3 $85.0 $88.1 International Sales $15.5 $18.0 $19.8 $21.2 $23.3 Sales of Established Products* $73.9 $75.1 $74.4 $76.3 $76.6 Sales of New Products $16. $19.8 $24.7 $29.9 $34.8 Hesearch and Development $0.9 $1.1 $1.5 $1.2 $1.3 Return on Assets 2.0% 2.3% 2.7% 4.19% 4.29% Number of Employees 480 485 502 492 510 Note: Dollar figures are in millions. "Established products are chose chat have been marketed for five years or more. New products have been marketed for less than five years. Exhibit 2: Exhibit 3: Summary Income Statement for Patterson Manufacturing Distribution of Current Patterson Employees by Job Title Year 5 Number of Average Salary Sales $90.2 Job Title Employees Per Employee Cost of Goods Sold (COGS) 74.3 Administrative Manager 10 $45,000 Gross Margin 15.9 Administrative Staff 24 12,000 Administrative Costs Production Supervisor 60.00 1.6 29 Selling Costs General Production Personne 417 11.2 37,000 Operating Income $ 3.1 Note: Dollar figures are in millions. Incerest expense and income taxes are only shown on Columbia's consolidated financial statements. Exhibit 4: Off-Shore Supplier's Price Proposal for the Volume of Product in Year 5 ABOUT IMA" Material Costs $12.7 With a worldwide network of more than 65,000 professionals, Labor Costs 1.8 IMA (Institute of Management Accountants) is the world's Overhead Costs 2.7 leading organization dedicated to empowering accounting Other 1.5 and finance professionals to drive business performance. Total 18.7 IMA provides a dynamic forum for professionals to advance their careers through CMAS (Certified Management Profit Mark-Up (10%) 19 Accountant) certification, research, professional education, Total Price $20.6 networking, and advocacy of the highest ethical and Note: Dollar figures are in millions. The vocal price is quoted for supplying the quantity of professional standards. For more information about IMA, product Patterson sold in Year 5. The quoted price is FOB the supplier's manufacturing plant. please visit www.imanet.org. IMA EDUCATIONAL CASE JOURNAL 3 VOL. 6. NO. 4, ART. 1. DECEMBER 2013