1. Introduction This report examines various proposals raised by different managers of Dumbellow Ltd. The major issue addressed by these proposals is “how to deal with product Z which is currently resulting in losses and thus pulling down the net profit of the entire product line”. The financial controller proposed a termination of the production of the product while the marketing manager suggested a £1 per unit reduction in the price so as to increase the demand of the product. On the other hand, the managing director thought that a 10% increase in both sales and activity across the board would make a difference.
Furthermore, the production manager considered re-organization of production activities and also the use of a cheaper component of product Z. though all these proposals are viable; they have various shortcomings which may outweigh their expected benefit. In addition, a comparison of marginal costing and full costing (absorption costing) is dealt with in this report. The advantages of using marginal costing instead of full costing, in decision making, are discussed. In conclusion, the shortcomings of the analyses of various proposals examined in this report are identified.
Recommendations on the best way to handle the case of product Z are also discussed at the end of this report. Key strategies that were recommended include reorganization of the production processes and the termination of the product. 2. Background Information Dumbellow Ltd is a manufacturing company that produces three industrial valves which are incorporated into equipment used in the Oil and Gas industry. The board of Directors of the company is meeting on 3rd of October to discuss the draft budget for the following year, a few months before the start of that calendar and financial year.
They are concerned about two issues; the deterioration of product Z in terms of its profitability in the present period and the financial year and the failure of the company to make a total profit of at least £400k to meet their required 20% return on capital. Owing to the dissatisfaction of the board, the managers of Dumbellow Ltd raised varying proposals on ways to boost the profitability of the company. These diverse views prompted the formation of a group of five members with an objective of writing this report and making recommendations to the board on the most optimal course of action (Lewis, 2001). . Marginal Costing and Absorption Costing Marginal costing, unlike full costing, focuses on the additional costs of producing one ore more units of a product or service. Under this method, the cost of materials and labour are the only components which make up the marginal cost. Other costs such as rent and taxes are considered fixed since they will have been covered. For this reason, marginal cost is easier to compute and thus preferable for quick decision making. Besides saving on time, marginal costing it helps in the generation of additional profit.
Every organization aims at maximizing profits which in turn facilitates growth of the business organization. One of the ways of maximizing profits is through reduction or minimization of costs, mostly the costs of production. Dumbellow ltd, for example, through marginal costing can utilize the spare capacity available to produce more of their products. In this case, fixed costs will not be considered since they are already paid; only labour and material costs matters. This enables managers to see quick means of generating extra profit.
However, if full costing is used by the company to access the cost of producing extra units, it will be found unprofitable or t result in negligible profits because of fixed costs included and it will require a lo of time (Elliot & Elliot, 2004). Marginal costing brings about better performances but significant risk is experienced. Businesses using full costing sets their prices by ensuring that all costs are covered and a profit margin is also included. This calculated profit can be reliably achieved.
On the other hand, businesses using marginal costing sets their prices by estimating the highest customer will pay, competitor’s prices and market prices are also considered. This price is designed to cover the marginal costs and is relatively lower. It is expected that lower prices would stimulate demand, maximize profits or increase the market share. A similar case, applies to production volume; in marginal costing, higher volumes of production are set due it the expected increase in demand stimulated by lower prices. All these are speculations which are risky but have worked for most companies.
Marginal costing may not be sustainable in the long-run because fixed costs will have to be recovered by the firm. It is also worth noting that this method can make the consumers to continually expect lower prices thus making it difficult to raise prices again. This would impact negatively on the profitability of firms during financial bloom or even when the firm wants to recover its fixed costs. However, it works well during financial crises since the firm that uses marginal cost will remain competitive in terms of low prices.
Proposals Proposals are the strategies that were raised by the Financial Controller, the Production Manager, the Marketing Manager, and the Managing Director. The main aim was to provide an optimal way of dealing with product Z which was unprofitable and was expected to deteriorate further. This section determines the overall contribution of each of the strategies and their impact on the original budget. Marginal costing, which considers variable costs only, is used to ascertain the contribution of each strategy.
In addition, personal judgment is used to expound on the comments made by the managers of Dumbellow Ltd while discussing the various strategies that could be pursued. As tools for elaborating the impact of various strategies, summarized statements, showing the impact of the various strategies on the sales and costs, are clearly presented. 4. 1 Termination of Product Z Paul Burns suggested that the company should stop the production of product Z. He argued that by doing so, fixed labor costs (£90) associated with this product will be eliminated.
In addition, £5 will be realized from the sale of old machines that are used to produce the product. Paul further stated that these machines are fully written off but can still be sold to gain some money. However, Paul also estimated redundancy costs, which will result from lay off of employees, to be £50. The net effect of this strategy is £45 = £5(sale of old machinery) + £90 (fixed costs eliminated) – £50(new redundancy costs). The statement below shows the impact of this strategy on the original budget: | |Product
X |Product Y |Product Z |Total | | |‘000 |‘000 |‘000 |‘000 | |Sales | | | | | |100k units at £15 |1500 | | |1500 | |80k units at £25 | |2000 | |2000 | |gain on sale of old machinery | | |5 |5 | | Total Revenue | | | |3505 | |Materials |300 |400 |(90) |610 | |Labour |700 |800 | |2160 | |Overheads |225 |360 | |585 | |Redundancy costs | | |50 |50 | | Total Costs |1225 |1560 |(40) |2745 | |Profit/Loss |275 |440 |45 |760 | Though this strategy is promising, it is rejected by the production manager who is among the oldest employees in the company.
Arthur wanted more time to look into ways of saving costs in the production processes despite the fact that he had failed to try activity based costing that was suggested by Paul during the previous year. Activity based costing, unlike the traditional costing method used by Dumbellow Ltd, assigns indirect costs to products by identifying the activities of the firm. It is process oriented and use cost drivers such as number of batches, instead of volume related allocation such as direct labor hours.
Cost drivers are estimates of the actual cost activities and they are related to the actual processes. ABC is not only a method of costing but also a totally new way of managing the organization effectively; it links cost information to other information and identify new improvement ways than the traditional costing method. The production manager and the whole management team of Dumbellow Ltd should reconsider ABC as earlier on suggested by the new financial controller (Paul Burns). This will enable them to find more effective ways of turning back product Z into a profitable product. . 2 Reduction of the Price of Product Z by £1 Bob berry, the marketing manager, suggested a £1 per unit reduction of the price of product Z and asked Arthur, the production manager, to save a similar amount in order to recover the loss. This is expected to raise the demand of the product by 25% which means increase in production by the same percentage. Net effect: Increase in sales revenue 25/100(120k) =30k*£9= £270k Savings on production = £1(120k+30k)= £150k Increase in material costs= £480/120*30 = £120k
Increase in labour costs= (750-90)/120*30k=£165 Increase in overhead costs= (15min/60min)* £5*30k=£37. 5 The net contribution therefore =270+150k-120k-165k-37. 5k =£97. 5 The statement below shows the impact of this strategy on the original budget; | |Product X |Product Y |Product Z |Total | | |‘000 |‘000 |‘000 |‘000 | |Sales | | | | | |100k units at £15 |1500 | | |1500 | |80k units at £25 | |2000 | |2000 | |150k units at £9 | | |1350 |1350 | | | | | |4850 | |Materials |300 |400 |600 |1300 | |Labour |700 |800 |915 |2415 | |Overheads |225 |360 |367. |953 | |cost savings on production | | |-150 |-150 | | |1225 |1560 |1410 |4518 | |Profit/Loss |275 |440 |-382. 5 |333 | As shown in the statement above, reducing the price of product Z by £1 would not improve the profit but leads to a further deterioration. In fact, lowering the price is not enough to trigger sales increase by over 25%, additional promotional costs such as advertising are required. In addition, owing to the expected increase in demand, production of this product has to be increased resulting in additional production and other costs.
For this to be successful there has to be a spare capacity. It may not be easy for the production manager to recover the £1 as suggested by the marketing manager. First, time for acquiring extra materials to meet the need for increased production is limited. Raw materials may have to acquire at a higher cost than normal since they were not planned for. Secondly, it is the same manager who has been there for a long time and has not done well in managing production costs. So, how can he save £1 per unit within a short period of time?
Furthermore, it appears that there are no tools for monitoring the production processes. The production manager had rejected the analysis of costs that was suggested by the new financial controller. If he had been using activity based costing, saving £1 per unit would be an easy task and it would take a short time to find ways of doing so. This strategy requires provision of more information to substantiate the claims of the marketing manager. Otherwise, it is not a viable strategy for improving the profitability of product Z. 4. 3 10% Sales and Activity Increase
The Managing Director, Ben Kates, proposed a 10% increase in sales and activity across the board, while holding the price and other factors constant. He thought that there was enough spare capacity to implement this strategy. This strategy generates a contribution of -12k as shown below: | |Product Z | |Sales increase by 10% |‘000 | |12k units (120/100*100) at £10 |120 | | | | |Materials 12units*(480/120) |48 | |Labour 12units (750-90)/120 |66 | |Overheads 12*330-150/120 |18 | |total marginal cost |132 | |marginal Profit/Loss |-12 |
However, the impact of the same strategy on the original budget is -372k as under: | |Product X |Product Y |Product Z |Total | | |‘000 |‘000 |‘000 |‘000 | |Sales | | | | | |100k units at £15 |1500 | | |1500 | |80k units at £25 | |2000 | |2000 | |132k units at £10 | | |1320 |1320 | | | | | |4820 | |Materials |300 |400 |528 |1228 | |Labour |700 |800 |816 |2316 | |Overheads |225 |360 |348 |933 | | |1225 |1560 |1692 |4477 | |Profit/Loss |275 |440 |(372) |343 | From the foregoing statements, it is clear that increasing the sales and activities of product Z by 10% would increase its losses by £12k.
It is also unrealistic to hold the price of product Z constant and expect such an increase in sales, as suggested by the Managing Director. How would a 10% sales increase achieved without incurring additional costs? Though not confirmed by the Production Manager, the managing director also mentioned that there was a spare capacity that could be utilized. In spite of the spare capacity, there are other additional costs that would be incurred but were not considered. Such costs include additional labor and increase in overheads.
This strategy needs further analysis without holding any factor constant. 4. 4 Reorganization of Production Activities Through the influence of the Managing Director, Arthur looked into ways of reorganizing production activities so as to improve processes. He realized that reducing fixed labour supervision could lead to reduction of fixed labor costs by £75k but would increase the variable overhead component by 10%. He also suggested the use of a cheaper component of product Z which would save £0. 75 per unit. In this case the total contribution= £75k+ (120k units*£0. 5)-10 %( 330-15min/60min*120k*£5) = £147 | |Product X |Product Y |Product Z |Total | | |‘000 |‘000 |‘000 |‘000 | |Sales | | | | | |100k units at £15 |1500 |0 |0 |1500 | |80k units at £25 |0 |2000 |0 |2000 | |120k units at £10 |0 |0 |1200 |1200 | | | | | |4700 | |Materials |300 |400 |390 |1090 | |Labour |700 |800 |695 |2241 | |Overheads |225 |360 |348 |933 | | |1225 |1560 |1485 |4288 | |Profit/Loss |275 |440 |-303 |412 | Though the re-organization of production activities is based on many assumptions in this analysis, it could contribute £147 and reduce the losses of product Z to £303 as shown in the statements above.
Reducing labor supervision is advisable as long as the quality of production is not negatively affected. However, the supervisors may be require further training so that the can manage wider labor force. This comes with additional costs that were not considered in this analysis. On the other hand, using a cheaper component of product Z may lead to poor quality products that may end up reducing the sales volume. In addition, the cheaper component could result in many wastages and defects.
Increased defects translate to increased material costs and labor costs (which result due to increased machine hours). All these issues were not taken into consideration. Therefore, more information is required to clearly determine the viability of this strategy. 5. 0 Shortcomings and Recommendations A major limitation in these analyses is the limited information available. The information provided is not enough to conduct an accurate analysis. Increasing sales by 10%, for example, does not mean that production will be increased by the same percentage.
Also, reducing the price of the product does not necessarily result in increased sales unless extra costs are incurred in marketing and selling. In short, many assumptions have been made during these analyses. Another shortcoming is the difficulty in turning some information into financial figures. For instance, laying–off some employees after stopping the production of product Z might result in demotivation of the remaining employees. This would definitely result in reduced production and possibly, customer dissatisfaction. So, how are these non-financial results incorporated into the financial data?
In this report, non-financial impacts are not captured and thus more information and further analyses is required to come up with a better solution on how to deal with product Z. It would have been more informative if additional background information about the company was provided. Information on the production structure of the company, production processes including the labor force required, customers’ and other stakeholder’s of the company, would have assisted in the through analysis of the strategies suggested by various managers.
In addition, information on the other two products would have been helpful in making comparisons in terms of similar costs. Even though, basic information of the product such as material costs, labor costs and overhead costs were provided, the other information would have helped in understanding the company’s operations for through analysis. The managers of Dumdellow Ltd need to consider the adoption of the Activity Based Costing (ABC) method which was suggested by the new financial controller during the previous year.
ABC costing method is more effective as compared to the traditional costing method applied by the company. It identifies the cost drivers and matches them to the products thus determining the cause and effects of such activities. ABC costing method would be of great use to the production in the re-organization of the production processes. Dumbellow Ltd should therefore adopt ABC costing method in order to turn around the profitability of product Z. From the analyses, it would be advisable for the company stop producing product Z.
This is because it is eating up the profits of the other two products and doing away with it would be more favorable in terms of the company’s profitability. Though reorganization of production activities results in huge marginal profits (£147), the total profit is less than that of the two remaining products if Z is terminated (Goodyear, 2009). However, reorganization of the production process could have been the most favorable strategy because of its potential to make product Z the most profitable among the three products.
It would also safeguard the good will of the company since it would not result in redundancies as compared to termination of the product. The redundant employees could sue the company leading to additional litigation costs and probably huge losses resulting from the compensation costs. In addition, termination of product could adversely affect the market share of Dumbellow Ltd because the users of the product would be affected. It may also drive away existing and potential investors in the company.
From the above discussion, it appears that termination of product Z, though it would result in higher profits, has many contingencies that may adversely and materially impact on the company’s financial position and its picture in the eyes of the customers and other stakeholders. This report, therefore, recommends the reorganization of the production processes which resulted in a positive net contribution and has no serious contingencies as compared to the termination of the product. Dumbellow Ltd should adopt the Activity Based Costing method in order to effectively and efficiently re-organize its processes.