Result of a wrong overhead cost assignment The main problem of a Sippican corporation was a low pre-tax operating income (1.8%). To solve that problem, a cause had to be found. Sippican reported gross margins of 35% on valves, 5% on pumps and 38% on flow controllers. After looking at a gross margins of the three product lines, one would think that pumps were an issue to work on, and a main cause for a low operating income, because the pump sales accounted for 47,36% of a total sales in March with just 5% operating margin. However, the method of measuring the product profitability had to be questioned. To be more accurate, the method of assigning the overhead costs to each product line was the reason for inaccurate gross margins of the Sippican´s product lines. The method of calculating the manufacturing overhead used by Sippican would be accurate if every of their three product lines was of the same or similar complexity. More complex products require more indirect work so one cannot simply assign the overhead costs to the products proportionally to direct labor working hours on each of them.
However, that was exactly what Sippican was doing and what resulted in overvaluing the flow controllers (the most complex product line of Sippican), and undervaluing the pumps and valves. Moreover, that created the wrong image of Sippican´s product profitability which led to an inappropriate pricing strategy. Overhead assignment to products entirely or a contribution margin approach? It is obvious that overhead assignment to products entirely is very inaccurate in this particular case and that executives should abandon it, but the question is should they replace it with a method which is even more simple and which does not even include overhead costs in measuring the product profitability? The answer is yes, because by not including the overhead costs in the product profitability, executives will not get a wrong idea on which pricing strategy to impose. They would be just deducting direct costs from sales so they would not be getting the wrong picture of overhead costs.
For example, by using the overhead assignment to products entirely, the following happens: If the executives take a look at the gross margins calculated with the overhead costs assignment to products entirely (the figures at the top of exhibit 2), they will get an impression that pumps have a really low margin, and that there is no more space for their price decrease, even though competitors are constantly decreasing prices. So executives will get under a lot of pressure and probably make a wrong strategic move.
On the other hand, when they take a look at a contribution margin, they cannot get a wrong picture (just an incomplete one) because one cannot get a lot of information from looking just at the contribution margin (and the range of those figures is low so. So at least they won´t make a wrong choice because of the wrong picture of product profitability. Contribution margin approach is simpler and the picture is incomplete but at least it is not wrong. Exhibit SEQ Exhibit \* ARABIC 2 – Product profitability by contribution approach and by gross margins 552450571500
To conclude, it is better not to include overhead costs, then to include them and get the completely different picture of the real product profitability. Both methods are inaccurate but the latter is less inaccurate and simpler so that is the reason to adopt the contribution margin approach in which manufacturing overhead is treated as a period expense. The best way would be to use the time driven ABC method but if one is left to choose between the two choices offered, than the contribution margin approach would be better.
Practical capacity and capacity cost rate
Exhibit SEQ Exhibit \* ARABIC 3 – Practical capacity and capacity cost rates Workers/machines Shifts per day Productive working hours Working days Practical capacity (hours) Overhead expenses (March 2006) Cost per time unit of capacity Production employees 45 2 6 20 10800 $351,000 $32.50
Setup employees 15 2 6 20 3600 $117,000 $32.50
Machine 62 2 6 20 14880 $334,800 $22.50
Receiving and production control 2 2 6.5 20 520 $15,600 $30.00 Engineering 8 1 6 20 960 $78,000 $81.25
Shipping and packaging employees 14 2 6.5 20 3640 $109,200 $30.00 Differences in costs and profitability and the cause of their shifts Revised cost assignment revealed a big differences in product profitability. Gross margins were significantly different after revision because of the overhead costs that were unevenly distributed and flow controllers were the most responsible for such a huge difference between the costs and profitability margins. The complexity of flow controllers resulted in revised overhead costs of $63.42 per unit ($39.37, or 164% more than in previous calculations). Valves and pumps costs were undervalued by 26% and 34%, respectively.
The amount of setup hours contributed the most to those high overhead costs. The problem was in following: for every hour of setup performing, there was a cost for laborers ($32.5) as well as the cost for machines ($22.5), because machines could have been working instead of being idle. Exhibit 4 shows the impact of flow controllers on the total overhead costs distribution. 5524501270Exhibit SEQ Exhibit \* ARABIC 4 – Manufacturing overhead costs distribution 0Exhibit SEQ Exhibit \* ARABIC 4 – Manufacturing overhead costs distribution
The following categories were the main cost drivers of flow controllers: Production runs – the product needed a lot more runs per unit then the other two because it consisted of lot more parts Machines on setup – for every unit produced, machine was working for 18 minutes, and it was on setup for 40 minutes and 30 seconds Setup labor – because of the large amount of time to setup the machine for the production, flow controllers were responsible for almost 80% of all setup costs Engineers – were spending more than 60% of their time just on flow controllers In Exhibit 5, it is visible how very high overhead costs per unit of flow controllers caused a change in product profitability after measuring them with an appropriate method.
Flow controllers´ actual gross margin was negative (-4%) and pumps had a gross margin of 20% (15 percentage points more than with previous analysis) so there was still a space for price decrease in pumps if it becomes necessary to react to market pushing of prices. Exhibit SEQ Exhibit \* ARABIC 5 – Income statement with product profitability and cost analysis Valves Pumps Flow Controllers Reported Practical
1. Sales $592,500 $875,000 $380,000 $1,847,500 $1,847,500
1. Sales (%) 32.07% 47.36% 20.57% 100.00%
2. Direct costs $212,625 $453,125 $140,000 $809,000 $805,750 *per unit $28.35 $36.25 $35.00
2.1. Direct Labor Expense $92,625 $203,125 $52,000 $351,000 $347,750 2.2. Direct Labor Expense (%) 26.39% 57.87% 14.81% 100.00% 2.3. Direct Materials Expense $120,000 $250,000 $88,000 $458,000 $458,000 2.4. Direct Materials Expense (%) 26.20% 54.59% 19.21% 100.00% 3. Contribution Margin (1-2) $379,875 $421,875 $240,000 $1,038,500 $1,041,750 3. Contribution Margin (%) 64.11% 48.21% 63.16% 56.21%
4. Manufacturing Overhead $126,500 $249,375 $253,688 $654,600 $629,563 *per unit $16.87 $19.95 $63.42
*Old manufacturing overhead (@185%) $22.85 $30.06 $24.05 *Difference $5.98 $10.11 -$39.37
4.1. Machine expenses total $86,625 $154,125 $87,750 $334,800 $328,500 4.1.1. Machine-related expenses $84,375 $140,625 $27,000 $334,800 $252,000 4.1.2. Machine expense on setup $2,250 $13,500 $60,750 $76,500 4.2. Setup labor $3,250 $19,500 $87,750 $117,000 $110,500
4.3. Receiving and production control $750 $3,750 $8,438 $15,600 $12,938 4.4. Engineering $4,875 $19,500 $48,750 $78,000 $73,125
4.5. Packaging and shipping $31,000 $52,500 $21,000 $109,200 $104,500 5. Gross Margin $253,375.00 $172,500.00 -$13,687.50 $383,900.00 $412,187.50 5. Revised gross Margin (%) 43% 20% -4% 21% 22%
*Gross margin before 35% 5% 38%
*Difference 8% 15% -42%
6. General, Selling & Administrative Expenses $350,000.00 $350,000.00 7. Operating Income (pre-tax) $33,900.00 $62,187.50
7. Operating Income (pre-tax) (%) 1.83% 3.37%
To conclude, shifts in costs and profitability were caused by practical capacity that could have been utilized better. The actual capacity was lower than the practical so the costs could have been lower if the workers and machines were more productive. Actions to improve the company’s profitability
Based on the revised figures, executives should take the following action plan: Change the method of product profitability calculation – In the future, they should implement the time driven ABC method and assign the overhead costs to products to calculate the product profitability they should then decide on pricing and other strategies. Different pricing – Based on the revised figures and facts from the case, it is clear that executives should adopt a different pricing strategy for flow controllers. Valves: revised margin is 43% it is a sign that valves are doing good and that the prices should stay at the same level. Pumps: 20% margin there is still space for further price reductions if necessary. Executives should leave the prices at the same level and react to the market because pumps act as a commodity so further reductions could cause an unnecessary price war.
Flow controllers: on a negative margin (-4%) previous price reductions did not result in a demand decrease so executives should definitely raise the prices. Flow controllers are highly complex and hard to produce, moreover, there are lot of different types of them so there are probably not many competitors who could produce them. Therefore, Sippican should aim for a margin of 30% at least and increase the prices to reach that. So to reach a margin of 30%, prices should be set at $140 (price increase of 47%) on the condition that demand stays at the same level (which is highly unlikely). Challenge: Hard to predict the right price increase detailed market analysis is necessary. Price volume compromise has to be respected by the price-volume compromise analysis made, for 1% of price increase, the volume should not decrease by more than 1.56% in order to achieve the same profitability at least.
However, if the volume decreases by less than 1.56%, profitability will rise higher iso-profit line will be reached. Develop an incentive program to workforce for higher productivity – Executives should organize the teaching of the workforce the basics of TDABC in order for them to understand how to contribute their company. In return, a certain percentage (for example 30%) per every dollar saved should be offered as an increase in salary at the end of the month. Benefits: Better working atmosphere, satisfaction, higher motivation and a win-win situation for executives and a workers. Challenges: It is impossible to offer the perfectly fair incentive to every worker, basically the total labor savings would be divided by the number of workers and a certain percentage would be shared equally. That could cause unhappiness among those who consider themselves more productive than others.