Superior Manufacturing Company In February 2005, Herbert Waters was appointed general manager of the Superior Manufacturing Company by Paul Harvey, president. Waters, 56, had wide executive experience in manufacturing products similar to those of Superior. The appointment of Waters resulted from management problems arising from the death of Richard Harvey, founder and, until his death in early 2004, president of Superior. Paul Harvey had only four years' experience with the company, and in early 2005 was 34 years old. His father had hoped to train him over a 10-year period, but his untimely death had cut this seasoning period short. The younger Harvey became president when his father died and had exercised full control until he hired Waters. New Management Paul Harvey knew that during 2004 he had made several poor decisions and noted that morale of the organization had suffered, apparently through lack of confidence in him. When he received the income statement for 2004 (see Exhibit 1) showing a net loss of $688,000 during a good business year, he knew he needed help. He attracted Waters from a competitor by offering a stock option incentive in addition to salary, knowing that Waters wanted to acquire a financial competence for his retirement. The two men came to a clear understanding that Waters, as general manager, had full authority to execute any changes he desired. In addition, Waters would explain the reasons for his decisions to Harvey and thereby train him for successful leadership upon Waters's retirement. Upon taking office in February 2005, Waters decided against immediate major changes. Rather, he chose to analyze 2004 operations and to wait to see results for the first half of 2005. He instructed the accounting department to provide detailed expenses and earnings statements by products and departments for 2004 (see Exhibit 2). In addition, he requested an explanation of the nature of the company's costs including their expected future behavior (see Exhibit 3). Company and Industry The Superior Manufacturing Company made only three industrial products: 101, 102, and 103. They were sold by the company's sales force for use in the processes of other manufacturers. All of the sales force, on a salary basis, sold the three products but in varying proportions. Superior sold throughout New England and was one of eight companies with similar products. Several of its competitors were larger and manufactured a larger variety of products than did Superior. The dominant company was the Samra Company, which operated a branch plant in the company's market area. Customarily, the Samra Company announced prices annually, and the other producers followed suit. Price cutting was rare, and the only variance from quoted selling prices took the form of cash discounts. In the past, attempts at price cutting had followed a consistent pattern: all competitors met the price reduction, and the industry as a whole sold about the same quantity but at the lower prices. This continued until the Samra Company, with its strong financial position, again stabilized the situation following a general recognition of the failure of price cutting. Furthermore, because sales were to industrial buyers and because the products of different manufacturers were very similar, Waters was convinced Superior could not individually raise prices without suffering substantial volume declines. During 2004, Superior's share of industry sales was 12% for type 101, 8% for 102, and 10% for 103. The industrywide quoted selling prices were $24.50, $25.80, and $27.50 per 100 pounds of product, respectively. Manufacturing Strategy Superior's manufacturing strategy was based on the "dedicated factory" concept. That is, each of the three products was produced in its own factory within the total factory complex. The three product factories were referred to as 101 Factory, 102 Factory, and 103 Factory. Each of these product factories was horizontally integrated beginning with receiving and extending through raw material storage, production-process facilities, finished-product inventory, and shipping. In addition, each product factory had a dedicated direct labor force, which for accounting purposes included hourly workers, shift managers, and other manufacturing-related personnel assigned to each product factory. Indirect labor "floated" between product factories as needed. Typically, the Superior manufacturing facilities operated below capacity. Cost System The Superior Manufacturing Company maintained a simple cost system. It was used for strategic planning, product-line decisions, identifying manufacturing process-improvement opportunities, profitability analysis, performance evaluation, cost control, and inventory valuation purposes. Management's goal was to assign all of the company's costs to each of the three products in a way that would lead to the most useful product costs for the cost system's various managerial purposes. The cost system identified two categories of costs. The first category consisted of costs, such as material costs, that could be tied directly to the manufacture of specific products. All other costs were placed in the second category and referred to as indirect costs (see Exhibit 2). The cost system accumulated direct and indirect costs at the product-factory level before determining the individual product costs on a per unit basis. Since each of the three products was sold in 100-pound bags, per unit costs were expressed in terms of 100 pounds of finished product. The per unit cost was calculated by dividing the unit output into the respective product factory's total cost. Total cost was the sum of the product factory's direct costs plus allocated indirect costs less an allocated other-income amount. Allocated indirect costs included the company's interest cost related to bank loans. Costs designated as direct costs were assigned directly to the product factory in which they were incurred. For example, the cost of materials used to manufacture product 101 in 101 Factory was charged directly to the 101 Factory account. This material cost could be traced directly to 101 Factory through material purchase and requisition orders. Indirect costs were allocated to the product factories using a variety of allocation methods (see Exhibit 2). For example, the total company rent expense ($5,324,000) was allocated to each product factory based on its enclosed cubic space. Cubic space was selected as the allocation basis to capture the fact that the production process for each of the three products included enclosed scrubber towers that varied in height depending on the product produced. Using the cubic space as the allocation base, the total company rent was charged as shown in Figure A to each product factory. Figure A Actual Rent Expense Allocation Basis (cubic space) Total Company Rent ($5,324,000) Allocated Rent 101 Factory ($1,872,000) 102 Factory ($1,570,000) 103 Factory ($1,882,000) Source: Casewriter. The allocated per 100-pound rent cost of each product was derived by dividing the unit output of each product factory into the respective product factory's allocated rent. A standard cost system was introduced in early 2005. It was used to value inventories, prepare budgets, and analyze performance (see Exhibit 4). Next year's standard costs were last year's actual per unit costs adjusted for anticipated cost changes. Since Superior's three products were each sold in 100-pound bags, per unit standards were expressed in terms of 100 pounds of finished product. Drop 103? To familiarize Paul Harvey with his methods, Waters sent copies of Exhibits 2 and 3 to Harvey, and they discussed them. Harvey stated that he thought 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. In addition, he stressed the need for economies on product 102. Waters relied on the authority arrangement Harvey had agreed to earlier and continued production of the three products. Midyear Results In the first week of July 2005, Waters received from the accounting department the six months' statement of cumulative standard costs including variances of total company actual costs from standard (see Exhibit 4). It showed that the first half of 2005 had been a successful period. In order to expedite the availability of interim-period results, Superior did not determine actual product-line revenues, costs, and profits. Rather, product-line data was prepared using standard per unit data and actual unit sales. Reduce 101 Price? During the latter half of 2005, the sales of the entire industry weakened. Even though Superior retained its share of the market, its profit for the last six months was expected to be small. In November 2005, the Samra Company announced a price reduction as of January 1, 2006 on product 101 from $24.50 to $22.50 per 100 pounds. This created a pricing problem for all its competitors. Waters forecast that if Superior held to the $24.50 price during the first six months of 2006, the company's unit sales would be 750,000. He felt that if it dropped its price to $22.50, the six months' unit volume would be 1 million. Waters knew that competing managements anticipated a further decline in activity. He thought a general decline in prices of all products was quite probable. The accounting department reported that the standard costs in use would probably apply during 2006, with two exceptions: materials and supplies would be about 5% below the 2005 standard. Waters and Harvey discussed the pricing problem. Harvey observed that even with the anticipated decline in material and supply costs, a sales price of $22.50 would be below cost. Harvey therefore wanted the $24.50 price to be continued, since he felt the company could not be profitable while selling a key product below cost. Questions 1. Based on the 2004 statement of profit and loss data (Exhibits 1 and 2), do you agree with Waters's decision to keep product 103? 2. Should Superior lower as of January 1, 2006 its price of product 101? To what price? 3. 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? 4. 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 reports to management? List the strengths and weaknesses of this system and its related reports for the purposes 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? Exhibit 1 Profit and Loss Statement for Year Ending December 31, 2004 (000) Gross Sales Cash Discount Net Sales Cost of Manufacturing Manufacturing Profit Less: Selling Expense $18,383 General Administration 6,534 Depreciation 13.591 Operating Profit Other Income Net Profit before Interest Less: Interest Net Loss Source: Casewriter. $105,905 1,567 $104,338 65,251 $ 39,087 38,508 $ 579 205 $ 784 1,472 $ 688 Exhibit 2 Analysis of Profit and Loss by Products and Departments-Year Ended December 31, 2004 (thousands $ except per 100 lbs.) Product 101 Product 102 Product 103 Classification per 100 lbs. per 100 lbs. per 100 lbs. Total Direct Indirect Allocation Basis Rent $ 1,872 $.88 $ 1,570 $1.53 $ 1,882 $ 1.90 $5,324 X Cubic space Property Taxes 621 29 503 49 401 .40 1,525 X Area Property Insurance 5241 25 405 .39 534 .53 1,463 X Value of equipment Compensation Insurance 836 39 439 42 458 .46 1,733 X Direct labor ($) Direct Labor 12.937 6.06 6,107 5.92 6,879 6.97 25,921 Indirect Labor 4,413 2.07 2,124 2.06 2,309 2.33 8,846 X Direct labor ($) Power 220 .11 251 24 302 .31 773 X Machine horsepower Light & Heat 158 .07 130 .12 106 .10 394 X Area Building Service 109 .05 821 .08 75 .08 266 X Area Materials 7,641 3.59 4,716 4.58 4,851 4.91 17,208 Supplies 525 25 485 46 350 .36 1,360 Repairs 184 08 150 .15 104 .10 438 xxx X Total $30,040 $14.09 $16,962 $16.44 $18,249 $18.45 $ 65,251 Selling Expense 9,100 4.27 4,582 4.44 4,701 4.76 18,383 X $ value of sales General Administrative 3,451 1.62 1,300 1.26 1,783 1.80 6,534 $ value of sales Depreciation 5,659 2.65 4,274 4.16 3,658 3.70 13,591 X Value of equipment Interest 524 25 409 .39 539 .53 1,472 X Value of equipment Total Cost $48,774 $22.88 $27,527 $26.69 $28,930 $29.24 $105,231 Less: Other Income 101 .04 53 .05 51 $48,673 $22.84 $27,474 $26.64 $28,879 .05 $29.19 205 X $ value of sales $105,026 Sales (Net) 51,672 24.24 25,996 25.23 26.670 27.03 104,338 Profit (Loss) $2,999 $1.40 ($1,478) ($ 1.41) ($2,209) ($ 2.16) ($ 688) Unit Sales (100 lbs.) 2,132,191 1,029,654 986,974 Quoted Selling Price Per Unit $24.50 $25.80 $27.50 Cash Discount Taken (% of selling price) 1.08% 2.14% 1.74% 1.48% Source: Note: Casewriter. Figures may not add exactly because of rounding. Exhibit 3 Accounting Department's Commentary on Costs Direct Labor: Variable. Union shop at going community rates. No abnormal demands foreseen. It may be assumed that direct labor dollars are an adequate measure of capacity utilization. Compensation Insurance: Variable. Five percent of direct and indirect labor is an accurate estimate. Materials: Variable. Exhibit 2 figures are accurate. Includes waste allowances. Purchases are at market prices. Power: Variable. Rates are fixed. Use varies with activity. Averages per Exhibit 2 are accurate. Supplies: Variable. Exhibit 2 figures are accurate. Supplies bought at market prices. Repairs: Variable. Varies as volume changes within normal operation range. Lower and upper limits are fixed. General Administrative, Selling Expense, Indirect Labor, Interest, and Other Income: These items are almost nonvariable. They can be changed, of course, by management decision. Cash Discount: Almost nonvariable. Average cash discounts taken are consistent from year to year. Percentages in Exhibit 2 are accurate. Light and Heat: Almost nonvariable. Heat varies slightly with fuel cost changes. Light a fixed item regardless of level of production. Property Taxes: Almost nonvariable. Under the lease terms Superior pays the taxes; assessed valuations have been constant; the rate has risen slowly. Any change in the near future will be small and independent of production volume. Rent: Nonvariable. Lease has 12 years to run. Building Service: Nonvariable. At normal business level, variances are small. Property Insurance: Nonvariable. Three-year policy with fixed premium. Depreciation: Nonvariable. Fixed dollar total. Exhibit 4 Profit and Loss by Products and Departments at Standard and Total Company Variances from January 1 to June 30, 2005 (thousands $ except per 100 lbs.) Product 101 Product 102 Product 103 Standard Item per 100 lbs. Total at Standard Standard per 100 lbs. Total at Standard Standard per 100 lbs. Total at Standard Total Standard Total Actual Variances += Favorable - Unfavorable. Rent $.88 $ 877 $1.53 $ 1,090 $ 1.90 $ 952 $2,919 $2,660 +259 Property Tax 29 289 .49 349 40 201 839 770 +69 Property Insurance 25 249 .39 278 .53 266 793 732 +61 Compensation Insurance .39 389 .42 299 46 231 919 917 +2 Direct Labor 6.06 6,041 5.92 4,216 6.97 3,496 13,751 13,820 -69 Indirect Labor 2.07 2,063 2.06 1,467 2.33 1,168 4,698 4,485 +213 Power .11 109 24 171 .31 155 435 432 +3 Light & Heat .07 70 .12 85 .10 50 205 200 +5 Building Service .05 50 .08 57 .08 40 147 107 +40 Materials 3.59 3,579 4.58 3,261 4.91 2,461 9,301 9.282 +19 Supplies 25 239 .46 328 .36 180 747 750 -3 Repairs .08 79 .15 107 .10 50 236 251 -15 Total $14.09 $14,034 $ 16.44 $11,708 $18.45 $9,248 $34,990 $34,406 +584 Selling Expense 4.27 4,257 4.44 3,162 4.76 2,386 9,805 9,830 -25 General Administrative 1.62 1,615 1.26 897 1.80 902 3,414 3,289 +125 Depreciation 2.65 2,642 4.16 2,962 3.70 1,855 7,459 6,817 +642 Interest 25 249 39 278 .53 266 793 730 +63 Total Cost $22.88 $22,797 $26.69 $ 19,007 $29.24 $14,657 $56,461 $55,072 +1,389 Less: Other Income .04 40 .05 36 .05 25 101 110 +9 $22.84 Actual Sales (net) 24.24 Profit (Loss) $ 1.40 $22,757 24,164 $ 1,407 $26.64 25.23 ($ 1.41) $ 18,971 $29.19 $14,632 17,961 27.03 13,550 ($1,010) ($ 2.16) ($1,082) $56,360 55,675 ($685) $54,962 +1,398 55,675 $713 +1,398 Unit Sales (100 lbs.) 996,859 712,102 501,276 Source: Casewriter. Actual unit sales times standard net revenue per unit. Instructions for the Superior Mfg case In your case memo answer question 2 from the Superior Manufacturing Company case using the additional data and other specific instructions below. Herbert Waters wanted a more detailed understanding of the company's pricing options for product 101, so he commissioned a brand new sales forecast to use in considering the product 101 price. In your response to question 2, use the prices and estimated sales quantities provided in Table 1 in place of the sales quantities estimated in the paragraph immediately under "Reduce 101 Price?" in the case study. The extended sales forecast assumes competitors do not match the price cut at $22.00 but rather follow Samra Corp. and price at $22.50. Table 1: Expanded sales forecasts. Price Sales forecast $24.50 750,000 $24.00 812,500 $23.50 875,000 $23.00 900,000 $22.50 1,000,000 $22.00 1,125,000 Waters asks you to do your analysis two ways: (A) using table 1 as presented which assumes the competition prices at $22.50; and (B), assuming competitors match the price cut to $22.00. In this second case, assume sales at $22.00 will be 1,000,000. Your memo should consist of the memo header as usual, then exactly two paragraphs of recommendations/explanations, and additional tables or figures if such additions help your explain your recommendations. ⚫ In the first paragraph offer a recommendation using assumption (A) above and provide enough explanation to convey a sense of your analysis and how it supports your recommendation; in the second paragraph offer a recommendation using assumption (B) above and provide enough explanation to convey a sense of your analysis and how it supports your recommendation. In your memo, be as clear as you on your recommendations and on how the results of your analysis back up your recommendations. A key here is, of course, identifying the relevant costs. Not all of the costs presented will vary with changes in output, so your challenge is to figure out just how to sort through the costs to decide which are relevant to the question to be answered. Note that the classification of costs into "Direct" and "Indirect" is helpful but not everything. Consider the information offered in Exhibit 3 in the case and how it relates to the question of relevant costs.