The Sippican Corporation Essay

Custom Student Mr. Teacher ENG 1001-04 7 June 2016

The Sippican Corporation

According to Sippican’s cost accounting system further decrease in the price of pumps would not be acceptable as because of the past price reductions the margin on pumps have already declined from the planned 35% to 5%. Detailed and alternative analysis of the costs – such as Activity Based Cost analysis – reveals alternatives for the management to decide on pricing, efficiency measures, and product development.

Sippican Corporation uses a simple cost accounting system for performance evaluation of the different products produced in order to be able to make future decision. Indications that it is not working properly are that even though the 3 products require different effort from overhead Sippican still assigns overhead costs at a flat rate across all products using a production-run direct labor cost allocation ratio assuming that there is a direct relationship between overhead and the output quantity based on this ratio. The disadvantage of it is that a huge amount of cost is determined based on a single driver. The case indicates that Sippican is extending its relations creating more complex and segmented orders for which the simple accounting system is too superficial.

Total manufacturing overhead of Sippican accounts for 35% of the sales revenue. The later detailed ABC analysis illustrates that significant differences arise in the cost to produce the different products. A more detailed cost analysis (vs. simple or contribution margin methods) provides a clear understanding of the costs and profitability of each product to support proper managements decisions or even avoid a financial/profitability crisis. Based on the above pros and cons Sippican should not abandon assigning overhead costs.

To calculate the overhead cost rates the total cost in the specified pools and the assigned driver and their amounts have been used. Exhibit 1 and 4 provide the appropriate figures keeping in mind that the amount of the driver is usage. Overhead rate equals the total cost in the pool divided by the total amount of driver (2/4).

Pool/activity Machine-related expenses Set-up labor Receiving and production control Engineering Packaging and shipping

Cost in pool $334 800 $117 000 $15 600 $78 000 $109 200

Cost driver Machine hours Set-up hours Runs Engineering hours Shipments

Total amount Overhead of driver Rate (2/4) 11 200 3 400 345 900 340 $29.89 $34.41 $45.22 $86.67 $321.18

With the overhead rate available the cost per unit for each of the 3 products can be calculated using the following equation: (overhead rate of driver * total amount of driver used) / number of units produced. 1 Cost element OH Rate 2 3 Valve =(1*2)/3 2 3 Pumps =(1*2)/3 2 3 =(1*2)/3 Flow controllers

Total Produced amount of # of units driver

Direct Labor cost Direct material cost Machine-related expenses $29.89 Set-up labor $34.41 Receiving and production control $45.22 Engineering $86.67 Packaging and shipping $321.18 Total cost per unit: Actual selling price of a unit: Gross margin Gross margin (%) Gross margin (%) of original method Delta

The ABC analysis of cost and profitability shows major differences in case of all products compared to the original Sippican cost structure analysis. Significant differences in gross margin are experienced in case of flow controllers and pumps. The traditional costing structure indicated that all 3 products had positive margins, however, with ABC the previously most profitable flow controllers in fact delivers a negative margin. No wonder they were sold steadily even after a 10% price increase. On the other hand pumps are not as bad in terms of margins as initially thought (5% vs. 18%). Not using a flat-rate cost allocation had significant affects on unit cost, especially in case of flow controllers where the original $59.05 increased by 67% to $98.80. Also ABC shows where further improvements per product are possible.

The figures provided in exhibit 1 and 4 needs to be tailored with the findings from Peggy Knight’s task force regarding Sippican’s overhead costs to define the amounts of each duration drivers. Assumption: 20 working days are used per month Machine-related expenses – Machine hours: 62 machines operate for 6 hours per shift. There are 2 shifts per day. Amount of driver = 62 machines * 6 hours * 20 days * 2 shifts = 14.880 machine hours Set-up labor – Set-up hours: 15 set-up workers working daily for 6 hours per shift. There are 2 shifts per day. Amount of driver = 15 set-up workers * 6 hours * 20 days * 2 shifts = 3.600 set-up hours Receiving and production control – Receiving hours: 4 employees working 6,5 hours a day. Amount of driver = 4 employees * 6,5 hours * 20 days = 520 receiving hours practically available Engineering – Engineering hours: 8 engineers working for 6 hours a shift (1 shift per day). Amount of driver = 8 employees * 6 hours * 20 days = 960 engineering hours Packaging and shipping – Packaging and shipping hours:14 employees working for 6,5 hours (practical availability) per shift. Amount of driver = 14 employees * 6,5 hours * 20 days * 2 shifts = 3.640 packaging and shipping hours practically available 1 2 3 4 5

Pool/activity Machine-related expenses Set-up labor Receiving and production control Engineering Packaging and shipping

Cost in pool $334 800 $117 000 $15 600 $78 000 $109 200

Cost driver Machine hours Set-up hours Receiving hours Engineering hours Pack.&ship. #

Total amount Overhead of driver Rate (2/4) 14 880 3 600 520 960 3 640 $22.50 $32.50 $30.00 $81.25 $30.00

Note! Production runs take 75 minutes per batch (1.25 hrs) therefore each batch/run costs $30*(75/60) = $37.50 / run Packaging takes 8 minutes (0.13 hrs) therefore to pack an item costs: $30*(8/60) = $4 / item Shipping takes 50 minutes (0.83 hrs) therefore each shipment costs: $30*(50/60) = $25 / shipment

Duration drives based on practical capacity give a marginal cost approach and in some cases a more precise result than the allocation based on the number of transactions (if production capacity is more or less efficiently used). Also, when there is a significant variation in the time required to complete an activity it’s a better measure of real costs. In the Sippican case using this method, the major impact is in case of packaging and shipping. The overhead rate decreased significantly by $292. The other overhead rates have also decreased, however, with less magnitude. 1 2 3 Valve =(1*2)/3 2 3 Pumps =(1*2)/3 2 3 =(1*2)/3 Flow controllers Cost per unit $13.00 $22.00 1200 2700 225 4000 4000 4000 $6.75 $21.94 $2.11 $12.19 $5.25 $83.23 $95.00 $11.77 12% 38% -26%

Cost element

OH Rate

Total Produced amount of # of units driver

Total Cost per Produced amount of unit # of units driver $12.35 $16.00

Total Cost per Produced amount of unit # of units driver $16.25 $20.00

Direct Labor cost Direct material cost Machine-related expenses Set-up labor Receiving and production control $22.50 $32.50 $30.00 3750 100 20 7500 7500 7500

$11.25 $0.43 $0.10

6250 600 100

12500 12500 12500

$11.25 $1.56 $0.30

Engineering $81.25 60 7500 $0.65 240 12500 $1.56 600 4000 Packaging and shipping $30.00 40 7500 $4.13 100 12500 $4.20 200 4000 Total cost per unit: $44.92 $55.12 Actual selling price of a unit: $79.00 $70.00 Gross margin $34.08 $14.88 Gross margin (%) 43% 21% Gross margin (%) of original method 35% 5% Delta 8% 16% In case of Receiving and production controll the method is: (OH rate * Amount of driver * Production run time in hrs) / produced # of units In case of Packaging and shipping the sum of the following methods is applied: Packaging cost per item + (shipping cost per item * amount of shipments)/produced untis

The time based ABC analysis relates costs to the production of the 3 products. It provides a clearer view of the cost structure. Flow controllers which in the traditional cost system were regarded as the most profitable product are the least profitable in the duration based ABC analysis. On the other hand it delivers better margin as we saw when using the transaction drivers. The major shift in the cost and profitability of flow controllers is due to the large costs associated with engineering and setup. A huge shift is visible in regard to packaging and shipping. Duration based ABC revealed a more accurate capacity usage based cost allocation. The significantly large packaging and shipping cost per unit for flow controllers decreased by more than 300%. This fact also reveals the necessity to analyze the unused capacity and its costs.

Total Overhead Pool/activity Cost driver amount Rate of driver Machine-related expenses Machine hours 14 880 $22.50 Set-up labor Set-up hours 3 600 $32.50 Receiving and production control Receiving hours 520 $30.00 Engineering Engineering hours 960 $81.25 Packaging and shipping Pack.&ship. # 3 640 $30.00 Total 23 600

Total used capacity 11 200 3 400 345 900 340 16 185

Unused Unused Unused capacity capacity # capacity % cost 3 680 25% $82 800 200 6% $6 500 175 34% $5 250 60 6% $4 875 3 300 91% $99 000 7 415 31% $198 425

Total theoretical cost of unused capacity is $198.425, 31% of the total overhead cost. Among the activities packaging & shipping overhead capacity is significantly oversized compared to actual usage. 91% of the capacity was unused in March, 2006. It has been noted that Sippican increased the number of customers it served in the last couple of years and therefore it expanded its packaging and shipping capacity, however, it seems that there is a potential to gain some cost reductions in this case. 50% decrease of unused capacity would result in ~$50.000 savings. Machine related overhead has in relative terms 25% unused capacity, however, its large absolute volume makes it account for $82.800 unused capacity cost.

Instead of traditional cost system use Activity Based Cost analysis. Use both duration and transaction number based methods to highlight inefficient use of available capacity and understand bureaucratic costs. Reevaluate the packaging and shipping capacity taking into consideration future plans of further customer expansion. If necessary further price increases can be made for valves (although the margins are even higher than initially calculated). Price elasticity of customer demand need careful monitoring. But the company seems to have a rather strong position based on the quality provided. Price is rather stable and no price competition yet For the pumps try reduce material costs and direct hours. Try to develop special pumps using the existing engineering capacity and quality level Further increase the price of flow controllers. It is a complex product with demand that already accepted a 10% price increase without any decline. The price here is definitely too low considering the margin. A price increase would help. The overhead is too big. Try reducing engineering and set-up costs. Setting up batches larger than currently could reduce set-up costs significantly. Try decreasing the complexity of the product by standardization (e.g.: decrease the variety).

Generally speaking the set-up costs are huge. Larger batches would reduce these costs. For pumps and perhaps valves, orders for larger batches should be acquired. A possibility to stimulate this is setting a higher basis price and lower prices the larger the batch gets. Another possibility is delivery time. Creating more flexibility here gives the company the possibility to run larger batches, so reducing set-up costs.

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