Analysis of the case2 Q1) Do you agree with Walters decision to keep product 103? 3 Analysis of Profit and loss statement 4 Sensitivity analysis6 Strategic scenarios8 Q2) Should superior lower as of January 1, 2006 its prices of product 101? To what price? 10 Q3) why did Supreme improve profitability during the period of January 1 to June 30, 2005? 13 Analysis14 Q4) why is it important that Superior has an effective cost system?
17 What is your overall appraisal of the company’s cost system and its use in report to management18 List the strengths and weaknesses of the system and its related reports for the purpose management uses the system’s output18 What recommendations, if any, would you make to waters regarding the company’s cost accounting system and its related reports? 19 Initial Analysis of Superior Manufacturing Company Case :- 1) After death of Richard Harvey (2004), founder and president of Superior Manufacturing Company (SMC), Paul Harvey took over.
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Paul Harvey had only 4 years of experience. Soon followed serious management problems because of some bad decisions made by Paul Harvey. The income statement of 2004 reflected net loss of $0. 68million in a good business year. To solve this problem Herbert Waters was brought over as General Manager of SMC. 2) SMC manufactured 3 different products namely 101, 102, 103 and was among the top 8 companies in the industry. Samra Company was market leader and announced price annually and other follow. Due to no product differentiation price cut was not an option.
The June 2004 market share of SMC product wise is given below; Products 101 102 103 Market share 12% 8% 10% Price per 100lbs 24. 5 25. 8 27. 5 3) SMC had a dedicated factory concept, where each factory produces only one product. Each product factory was fully horizontally integrated. SMC all plants operated below capacity. 4) SMC followed a simple cost system, which identified two categories of cost :- a. Direct Cost to manufacturing of specific product (direct labour, materials, suppliers, retailers) b. Indirect Cost (rent, property taxes, material cost etc. )
5) As SMC product was sold in 100lbs bags all cost are expressed in terms of 100 pounds. 6) Paul Hervey after studying the reports generated by standard cost system stated that product 103 should be dropped immediately, as it would be impossible to lower expenses on product 103 as much as $2. 16 per 100 pounds. But Herbert Waters exercised his administrative control and continued production of the three products. 7) In July 2005, six months statement of cumulative standard costs including variances of total company actual costs from standard, showed first half of 2005 has been a successful period.
8) During second half of 2005, entire industry sales weakened. Samra Company announced a price reduction (1 January, 2006) on product 101 from $24. 5 to $22. 5 per 100 lbs. This decline was a huge risk from for SMC’s most successful product. The prices will make the best product unprofitable. The two other products sold by SMC were already unprofitable. 9) The business production strategy and cost system employed by SMC does makes differentiation between indirect costs associated with each factory. Indirect costs constitutes for major part of the costs attributed to each product.
10) In 2005, SMC was faced with a financial decision related to continue production on all three of their factories or stop the least profitable one, product 103. With this they also had to decide whether to lower the price of their product 101 to match market leader Samra’s price. Q1. Based on the 2004 statement of profit and loss data (Exhibits 1 and 2), do you agree with Water’s decision to keep product 103? The analysis of all the probable scenarios are given below:- Scenario 1 If management decides to stop product 103, this can be achieved by: 1.
Stop product 103 and all business related to it. 2. Outsource production of product 103 and keep distribution of product 103. 3. Stop product 103 and the extra available production capacity is used for producing product 101 or 102. Scenario 2 If management decides to continue product 103, this can be achieved by: 1. Keeping the same volume of production. 2. Increasing the volume of production. 3. Decreasing the volume of production. 4. Substitute 102 capacity with 103; ( if 103 production facility can’t exploit economies of scale ) Analysis of Profit and Loss statement of 31 Dec, 2004
It becomes quiet clear from the first glance of Profit and Loss statement (2004), that product 103 is not profitable and incurring heavy losses. P&L clearly shows a loss of 2. 16$ per unit sold in product 103 (amounts a total of $2. 209 million). See below for the cost category classification:- Cost differentiation – Direct/Indirect (Product 103) in $ 000 Direct indirect Direct Labour(v) 6879 Rent 1882 Materials(v) 4851 Property Taxes 401 Suppliers(v) 350 Property Insurance 534 Repairs(v) 104 Indirect Labour 2309 Compensation insurance(v) 344 Light & Heat 106 Power(v) 302 Building Service 75 Compensation Insurance
115 12830 5422 % of total cost 70% 30 Total Cost 18,253 Note: – Selling expense, general administrative expenses are later covered in the sensitivity analysis. After closely looking at the above table, it can be obvious that indirect costs are very high. These indirect costs are 30% of the total cost. For analysis to achieve economies of scale and assuming production facility is working on full capacity. Under these assumptions plotting the price change related to volume change in production: Compen Ins(v) Direct Labor(v) Power(v) Materials(v) Supplies(v) Repairs(v) volume 276 4182 186 2946 216 60 600 322
4879 217 3437 252 70 700 345 5227. 5 232. 5 3682. 5 270 75 750 368 5576 248 3928 288 80 800 391 5924. 5 263. 5 4173. 5 306 85 850 414 6273 279 4419 324 90 900 437 6621. 5 294. 5 4664. 5 342 95 950 460 6970 310 4910 360 100 1000 483 7318. 5 325. 5 5155. 5 378 105 1050 506 7667 341 5401 396 110 1100 529 8015. 5 356. 5 5646. 5 414 115 1150 552 8364 372 5892 432 120 1200 575 8712. 5 387. 5 6137. 5 450 125 1250 598 9061 403 6383 468 130 1300 Volume (000) unit price Sales Profit(Loss) p. Unit Profit(Loss) total 600 35. 5 16212 -8. 5 -5117 700 32. 2 18915 -6. 2 -4367 750 32. 3 20266 -5. 3 -3992 800 31. 5 21617 -4. 5
-3616 850 30. 8 22968 -3. 8 -3241 900 30. 2 24319 -3. 2 -2866 950 29. 6 25670 -2. 6 -2491 1000 29. 1 27021 -2. 1 -2116 1050 28. 7 28372 -1. 7 -1740 1100 28. 2 29723 -1. 2 -1365 1150 27. 9 31074 -0. 9 -990 1200 27. 5 32425 -0. 5 -615 1250 27. 2 33776 -0. 2 -240 1300 26. 9 35128 0. 1 135 1400 26. 4 37830 0. 6 885 1500 25. 6 40532 1. 1 1636 After analyzing above tables it is clear that if management keep producing Product 3 and sell more than 1. 3 million units per year, it will bring profit to the firm. (As we didn’t take price change of any direct or indirect attribute because of simplicity of the calculation.
The results of the above analysis are not based under some assumptions. Therefore, for further analysis we did some sensitive analysis to check our analysis. ) Sensitivity analysis For recommending any strategic action for execution, variance between some key factors is taken into consideration. The objectives of our analysis are: 1. Possible changes of the market volume and company’s market share 2. Finding dependency of price and value of sales. 3. Calculating any possibility of profitability 4. Explore the tradeoff between keeping items in inventory vs. the aggressive pricing strategy and zero inventories. 5.
Incremental analysis for assessing Assests vs Profits. For making reference point of my work, below assumptions are taken into account before doing the analysis. a) There exists a linear dependency between price and market share. b) As stated in the case that factory is running under capacity. For ease of calculation and to have a starting point we assume that production facility 103 is using about (40-50%) of its total capacity. c) Total market of product 103 is 10 million, as SMC holds 10% of market share (0. 986 million units). d) Samra is price leader as there are only 8 competing firms. This market will behave as oligopoly market.
Which means Samra (45% market share), 4 other including SMC holds (40% market share) and two smaller companies (15% of the market share). For further analysis 3 possible scenarios were used:- Analyzing the market price for product 103 on production levels of 1. 1 million units, 1. 3 million units and 1. 5 million units, to check the price SMC needs to maintain to gain the desired market share. Below Analysis is self-explanatory Critical Indicators Economies of scale Adjusted for market conds. Volume (000) 1100 1100 Market Share 11% 11% Market Price 27 26. 2 Unitary Cost 28. 3 27. 9 Sales 29722 28340 Production costs 31806 30753
Critical Indicators Economies of scale Adjusted for market conds. Volume (000) 1300 1300 Market Share 13% 13% Market Price 27 24. 6 Unitary Cost 26. 9 26. 2 Sales 35126 31449 Production costs 34996 34109 Critical Indicators Economies of scale Adjusted for market conds. Volume (000) 1500 1500 Market Share 15% 15% Market Price 27 23 Unitary Cost 25. 4 24. 3 Sales 40530 33929 Production costs 38085 36492 As already seen the market scenario is very rigid and possibility for SMC to achieve economies of scale without gaining market share is not possible. The rigidity of the market is due to the variance of elasticity of demand. Strategic scenarios
Having in mind the analysis of the current situation we could offer some scenarios for strategic actions to the management of Superior Manufacturing. Referring back to the first paragraph we can explore the following options: If management decides to stop product 103, this can be achieved by: 1. Stop product 103 and all business related to it. 2. Outsource production of product 103 and keep distribution of product 103. 3. Stop product 103 and the extra available production capacity is used for producing product 101 or 102. 1. Stop product 103 and all business related to it – it will lead to SMC not producing not profitable product 103.
It will also save a loss of $2. 209 million assuming expected sales are 1million units. For checking the losses incurred via non variable, fixed expenses etc. Let’s assume that in next operating cycle SMC can do any of the following step:- a. Pay all the fixed expenses b. Not selling old machinery c. Reduce occupied working force Further analysis of this is done below Stop production Continue prod. Rent(non v) 1882 1882 Property Taxes(almost non v. ) 401 401 Property Insurance(non v) 534 534 Compensation Insurance(v) 458 458 Direct Labor(v) – 6879 Indirect Labor 2309 2309 Power(v) – 302 Light & Heat(almost non v,fuel dep.
) – 106 Building Sevice(non v) – 75 Materials(v) – 4851 Supplies(v) – 350 Repairs(v) – 104 Total 3093. 7 18429 Selling expenses(non v,changeable) – 4701 General Administrative(non v,changeable) 178 1783 Depreciation(non v,changeable) 3658 365 Intereset(non v,changeable) 539 539 Total Cost 7649 28930 Less:Other Income(non v,changeable) – 51 – 28879 Sales (Net) – 26670 Total loss 7469 2209 As seen from the above table it’s clear that stopping production in the near future SMC will incur huge losses. Therefore, SMC should continue producing product 103 instead of closing down the line as losses are relatively higher.
Knowing the current state and especially how specific is the industry it is highly unlikely that outsourcing can be an option. Moreover, increasing the existing capacity of product 101 (the only product that is making profits), that in turn will mean capturing higher market share. As per the current scenario, market is very rigid and flooding market with product 101 without cutting down price will not be an option. As 103 capacity shifts 101 there will be a need to capture twice the market share as existing. After considering the above analysis, my suggestion will be to continue the production of product 103.
To optimize this option production facility levels need to be revised again. Like earlier assumption that product 103 factory is working with 40-50% capacity, it can also happen its working under 90% production levels. Financial information regarding the SMC is needed because any good decision cannot be made without accessing financial health of SMC. 1. If the production of 103 is lowered down, it will temporary soften the transition towards the process of stopping production of product 103. But bringing production level less than 700,000 units is a very bad option as it will lead to huge losses.
2. If the production is maintained at same level, it seems a good approach if SMC plans to raise production level to achieve economies of scale. As per the current scenario market is very rigid and increasing market share will need company to pursue aggressive pricing policy. It can lead to price war which in turn will result in race for the survival of the fittest. 3. If production is increased can be a good solution if product factory 103 is running at 40-50% of operating efficiency. Q2. Should Superior lower as of January 1, 2006 its price of product 101? To what price?
As stated in the case study, market leader Samra Company brings the price variation in the market. Thus, analysing future scenario of SMC and the whole industry under the light of price fluctuations, Waters made two forecasts on company sales: i) Company sales during the first semester of 2006 under the original price of $ 24. 5 ii) Company sales after lowering the price to $ 22. 5 as the market leader plans to do. Waters also stated that if SMC kept original prices they will be able to sell 7,500,000 unit sales. Also if price reduction is applied as Samra planned to implement, SMC’s product sale will reach only 1,000,000.
Balance sheet of 2006 first half year has been formulated by reallocating the costs. The basis for calculation is allocating total cost to the department cost and finally calculating unit cost. Below are the assumptions for calculation of budget for first half of 2006: Company cash discounts will be same as given in the case. Total unit sold for product 102 and product 103 will be constant, unless strictly stated in the case. Unit cost of direct labour, repairs will be same and unit cost of materials, supplies will decreased by 5% as stated in the case.
Non variable costs will remain constant for rent, property taxes, property insurance, light and heat, building service, power, depreciation, interests). Non variable costs are recalculated for variables like compensation insurance, indirect labour, selling expense, general administrative, other income. At a unit price of $ 24. 5 and total sales volume of 750,000 units, after calculation total loss will come out to be $ 2. 207 million. Do see below for further calculation: Now calculating the financial implications if the price steeps lower (price $ 22. 5) as per the case and product sales volume rise up to 1 million units:
After going through the above analysis its clear Product 102 will keep SMC profitable. But in the later half of 2006, there will be huge losses to SMC because of allocation of variable and fixed costs. As in the first half of 2006 the cost will be distributed widely because of yearly sales unit target, but in the second half the costs will be distributed over few units. As both the forecasted prices analysis is done. It’s clear from the second analysis that SMC will have less loss in the second case of around $ 155,800. In both the alternatives suggested there are considerable losses.
To check if any intermediate solutions for this problem exist, this can be achieved if we know the function describing a relation between the demand and the price. To calculate and identify the interim solution below assumptions are taken into consideration: a) Constant elasticity between price and demand. For the purpose of analysis, a straight line trace was made between demand and price combination. The best situation arises at price $20. 36 and total sales volume of 1267367 units. At this particular level SMC will incur a loss of $148; it’s the minimum loss SMC will incur.
But this solution is not feasible for SMC, as SMC can’t lower its product price than $ 22. 5. After further analysis it becomes clear the best solution for SMC will be at price level $23 and demand of 975,000 units in the market as this will result in a loss of $ 471. (taking non linear dependency between demand and price of the product). Q3. Why did Superior improve profitability during the period January 1 to June 30, 2005? How useful was the data in exhibit 4 for the purpose of this analysis? The cost system used by SMC in 2005 was obsolete, highly unreliable and can’t check performance levels of different products and units.
According to the system suggested by us, the first half of the year 2005 was very profitable and was followed by major losses in second half of 2005. Due to the second half of 2005 the total losses were almost same as that of year 2004. Its quiet astonishing that without any major changes in fixed or variable costs, no price fluctuations and no major demand variations, SMC was able to improve its performance drastically. If you carefully look its clear from the balance sheets (exhibits 2, 4), product 101 and product 102 were selling 46. 75% and 60. 79% of their yearly sales in the first half of 2005.
Given below is the analysis done by me on revenues and cost. Revenues With the amount of data presented in the case, it’s clear that market is not growing in 2005. But this contradicts the fact that first half of 2005 was very good for sales. This can also be attributed to normal purchase cycle of industrial goods like reordering of inventories in higher volume to reduce the impact of logistics costs customers tend to buy product 102 in higher quantities in beginning of the year while towards the ending of the year clients tend to clear inventories and stocks. This can be attributed to a common behavior among the B2B segment.
This is done to achieve different goals like to minimize inventory costs, reducing net profit to evade taxes. As at the end of first half of 2005 (June) the sale of product was quiet high. This in turn means that fixed costs spread over a larger number of quantity, hence improve in profitability can be attributed to this also. But this profitability is short lived as the second half of 2005 will worsen (because of less sales volume), but this can’t be entirely true. As there is no data for the end of 2005, under the following assumptions: a) Market will remain stable or decreasing
b) Large sales volume in first half and this means low sales volume at the end of 2005 c) Product 102 will cover fixed costs of second half (with 30. 84% sales volume) For correct evaluation we need data related to inventory of SMC. As if end of 2005 has higher stock that will also be accounted for money. Costs The cost accounting system used by SMC was correctly allocating direct costs (Direct Labor, Materials, Supplies, and Repairs); Attributing direct costs directly to products and computing unitary cost and multiplying it with actual sales.
From the case its already clear that there no variances between raw materials. But please take into consideration that this system uses unit costs from the previous year. This particular aspect of costing system also makes sure that fixed/variable costs are allocation on previous year but for smaller period than actual annual time. For example if SMC produces a lot in one year, then SMC’s should not spend more on rent, property insurance, property taxes and other fixed costs. This is unrealistic and in first half of 2005 these deviations can be clearly seen.
This leads to violation of competence cost. Please see below: Rent (fixed – allocated on cubic space) Property taxes (almost non-variable, based on the area being used) Property insurance (non-variable, based on the equipment being used) Indirect labor (almost non-variable) Building services (non-variable, based on the area being used) General administrative (almost non-variable, depends upon sales volume) Depreciation (non-variable, based on the life of the equipment) Interests (almost non variable) All the cost mentioned above are expected to very high as the unit cost of
previous year for product has been multiplied the actual cost. These costs shouldn’t be that high. Also compensation insurance remains almost the same and doesn’t depend upon the sales volume. Power cost also remains the same as 4148819 units produced in 2004 and 2210237 units produced in first half of 2005 represent the 53% of total production. Light and heat costs are little higher than the standard cost it can probably be attributed towards winter season (for industries located in northern hemisphere). Below tables have been made by recalculating in 2 different ways.
The column named “our suggestion” – the calculations (budget) have been done by attributing fixed and variable costs of the current half year with the previous year annual result (dividing the annual cost in 2 parts). Direct costs are calculated by taking unit cost of previous year and actual sales volume. In the column “hybrid” same method is used for only actual sales and costs. The unit costs relative to second column are given in other columns; the direct variable costs only present the same unit costs of the previous years.
When checking profit the difference between “our suggested” method and the “hybrid” is due to the increased cost of selling expenses. As the market conditions were bad, rigid and worsening cause increase in selling expenses. After the analysis of second half of 2005, it seems that our hypothesis was right about unexpected profitability in the first half of 2005. The final situation of 2005, will be clear from the below table and it becomes quiet clear that losses were similar to 2004 and only difference is due to the use of previous selling expenses.
From the analysis done by us, it clearly explains how inaccurate is Exhibit 4 and why it is inaccurate is clearly stated in Answer 4. The advantage of this system is its timeliness as it allows getting results of half year exactly one week later. On contrary the system used by SMC used to consider full costs and allocate them on products was flawed. It rarely gives any useful advice to management. Production of higher quantities will help in recovery of fixed costs. But this will only be beneficial if production is tied up with expenses of sales.
This can only be possible if sales are not rapidly increased otherwise it will be useless to run factory on full capacity. Q4. Why is it important that Superior has an effective cost system? What is your overall appraisal of the company’s cost system and its use in report to management? List the strengths and weaknesses of the system and its related reports for the purpose management uses the system’s output. What recommendations, if any, would you make to Waters regarding the company’s cost accounting system and its related reports?
Why is it important that Superior has an effective cost system? An effective costing system is a need in today’s dynamically changing manufacturing scenario. It helps management to track its processes/products and to get clear understanding about the functioning of the same. It also helps management in analyzing what was planned and how it actually working, this helps in planning future scenario of activities and strategies for company. Effective cost system is a need for SMC because of the following reasons: a) In last two years top management of SMC has changed twice.
With the change in top managers, it is very much clear that they will be unfamiliar with the working of their previous counterparts and strategies planned and executed by their previous. As market scenario is worsening year after year and major changes in the management leads to a very demoralizing effect amongst the employee. The new cost system will be very helpful in the current scenario for SMC as it help the managers in following manners: a. To understand and analyze historical data. b. Position of company in the market c. Helping in pointing out the flaws d.
Lays out a clear course of action for the management. b) SMC is facing rigid market conditions and strong competition (price leader in the market are superior in terms of manufacturing capacity, financial health). In scenario like this competitive advantage can only be attained by cutting price of production. Thus, its very important for SMC to have perfect expense, cost and revenue system. It will become easier to identify major factors in lowering costs and choosing better strategic actions if the cost system is good. What is your overall appraisal of the company’s cost system and its use in report to management?
According to the case it’s clearly stated that all the factories are horizontally integrated. That means raw material, storage, product-process facilities, finished-product inventories and shipping all are included in one particular factory processes. The current system doesn’t provide very reliable, aggregated and unpunctual information. The SMC at present using the system in order to do its strategic planning, product-line decisions, identifying manufacturing process-improvement opportunities, to conduct profitability analysis, performance evaluation, cost control, and inventory valuation purposes.
Also SMC is using the same costing system for: Perform planning Control activities and processes For short-term strategic decisions, For long term strategic decisions, As its very clear that different data is needed for different information and decision making. The current system is good for supporting, planning short-term decision making for marketing, product, business and senior managers. But this system can’t support planning and control. Most of the problems of the company are in this sector itself. List the strengths and weaknesses of the system and its related reports for the purpose management uses the system’s output.
As its clear from the previous analysis that costing system can’t be evaluated in absolute terms. Strengths: the current system has lot of imperfections but it also helps management in some purposes: Timeliness – according to the case it states that first half statement of 2005 statement was issued at end of first week of July. When information is needed rapidly its better to adopt this kind of system. Low Cost – As most of the information needed to prepare financial reporting uses previous years and sales force data it comes out to be very cheaper.
As the accounting happens annually unless and until explicitly ordered then for half yearly. The reports generated are simple bookkeeping reports and hence turns out to be very cheap. Simplicity – the reports generated by system are very simple. As data given is very aggregated and it helps new managers to get basic understanding of state of affairs of the company very easily. Weaknesses: the system is unable to fulfill some of the basic purposes for which the system was designed like: Incorrect allocation of costs on non full operating cycle,
Only simple data, Not enough detail in the data, What recommendations, if any, would you make to Waters regarding the company’s cost accounting system and its related reports? For better execution of strategies and strategic actions the below recommendations can be considered: Management should rectify SMC’s existing costing systems, to report correct mid-term results and to make better decisions. For planning & controlling activities and processes level At the level of short-term strategic decisions. At a long-term strategic level
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