Sippican Case

1 SIPPICAN CORPORATION CASE ANALYSYS 20229 Cost Management System 2 Executive Summary ? Company Overview ? Accounting method ? Production process ? Activities performed ? Q1. Should Sippican use a contribution margin approach? Explanation ? Q2. Capacity cost rates for resources ? Q3. ? a. Revised costs and profits ? b. Product costs and profitability analysis with the new allocation method. Cause of the shifts in values. ? Q4. What actions should the management take to improve Sippican’s profitability? 3 Company overview • Sippican is a company manufacturing hydraulic control devices: alves, pumps and flow controllers • Recent trends (March 2006) ? Valves: margin remained at standard 35% ? Pumps: Sippican’s main business, gross margin fell to 5% (below expect. 35%) ? Flow controllers: price increase by 10% with no effect on demand • Issue Sippican had to react to competitors pumps price reductions to maintain volumes Decline in profitability: pre tax margin to less than 2% 4 Competitive scenario Sippican • High quality • Unique design • Loyal customer base • Major supplier • High volumes • Commodities • Major presence • Customized • Various types

Industry Able to match Sippican’s quality, but no bids for market share with price cuts Sippican’sReaction Stable 35% gross margin Valves Pumps Price reduction Price reduction & consequent decline in profitability More production runs and shipments to meet demand + 10% Price increase w/o affecting demand Flow Controllers Much variety of types in the industry 5 Accounting method • Simple cost accounting system , full cost method: ? DM costs= price of components (annual agreement) ? DL= 32. 5$/h (fringe benefits are included); charged on std run times for each product ?

OH allocated as % of production-run DL cost (185% current OH rate) • Variable costs are only DL and DM Meeting to consider the possibility of adopting a contribution margin approach 6 Production process Purchase Machine Assembly ? A unique product department ? Same equipments and labor for all the 3 product lines ? Just in time Valves • 4 components • Standardized • Large lots Pumps • 5 components • Standardized • Products go to industrial distributors after assembly Flow Controllers • Varied&customized: more components, more labor , more products runs 7 Activities Set up 2x 7. h/d shifts; 20 days per month • each time batch components is machined in a production run • 15 workers per shift (25% production workforce) • • • • • 62 machines Workers simultaneously at more machines 45 workers per shift (production&assembly workers) 5,400$/month operating expense Productivity: 6 per shift Production run Receiving and production control • Orderind, processing, inspecting, moving batch componetnts to production runs • 75’ (regardless type of production run & components price) • 4 people over the 2 shifts • • • • 50’ per shipment 8’ bubble wrap and pack 14 workers per shift (tot28) 7. h/d shift; 30’ training; 2×15’ breaks *Production& assembly workers: – 2x 15’ breaks 30’ training 30’ preventive mainteinance Packaging and shipping New product design and development • 9750$/m compensation • 7. 5h/d shift 8 Q1: Should executive adopt a contribution margin approach? Yes Costs-volumeprofits analysis No Variable costs:dm&dl significant contribution to oh Pricing decisions No account of all costs related to products Significant fixed costs JIT: no need to incorporate inventories NO: company cost structure significant fixed overhead costs and significant activities influencing the values of the final products the whole analysis will based on the contribution margin approach. The results which will be obtained will be influenced by the use of Time-driven ABC, with the right cost driver allocation to cost pools. It will make the difference for perfoming a more accurate analysis 9 Q2: Compute capacity rates for resources Hrs/month Monthly cost* Production workers 20 $3. 900 Indirect workers 20 $3. 900 Engineers 20 $9. 750 Machines 20 $5. 400 x Paid hrs 7,5 7,5 7,5 Productive hrs 6 6,5 6 12 ? Monthly hrs 120 130 120 240 Cost per hr $32,50 $30,00 $81,25 $22,50 DL Set up Machines Rec&Prod Pack&Shp Eng units 90 30 62 4 28 8 Monthly hrs 120 120 240 130 130 120 Hrs available Hrs used % Capacity used 10800 10700 99,07% 3600 3400 94,44% 14880 14600 98,12% 520 431,25 82,93% 3640 3483,33 95,70% 960 900 93,75% *given by the text Q2 Product data March 2006: 10 Product Lines Valves Pumps Flow Contr. DM units 4 5 10 DM cost 16 20 22 DL h/unit 0,38 0,50 0,4 Machine h/unit 0,5 0,5 0,3 Set up h/unit 5 6 12 Production Units Machine hrs (run time) Production runs Setup hrs(labor&machine) #of shipments Hrs engineering work Valves Pumps Flow Contr. 7500 12500 4000 3750 6250 1200 20 100 225 100 600 2700 40 100 200 60 240 600

Total 24000 11200 345 3400 340 900 Actual quantities per activity: Activities Set up hrs Machine hrs Receiving& control hrs Packaging & Shipment hrs Engeneering hrs Pr Units x DLhrs Mhrs+set up hrs(machine) 75’/60) x production runs (50’/60’) x #ship + (8’/60’) x pr. Units Eng hrs Valves 2850 3850 25 1. 033,33 60 Pumps 6250 6850 125 1750 240 Flow contr 1600 3900 281,25 700 600 Total hrs used 10700 14600 431,25 3483,33 900 Q3 Valves Pumps Flow Controllers Tot $592. 500,0 $875. 000,0 $380. 000,0 $1. 847. 500,0 $212. 625,0 $453. 125,0 $140. 000,0 $805. 750,0 $120. 000,0 $92. 625,0 $250. 00,0 $203. 125,0 $88. 000,0 $52. 000,0 $458. 000,0 $347. 750,0 11 Q3. a: Revised costs and profits for the 3 product lines Revenues VC DM* DL* Contribution Margin TOH* Machine related expenses Setup labor Setup Machine R&P Control P&S Engeneering $379. 875,0 $421. 875,0 $126. 499,0 $249. 374,1 $84. 375,0 $3. 250,0 $2. 250,0 $750,0 $30. 999,0 $4. 875,0 $140. 625,0 $19. 500,0 $13. 500,0 $3. 750,0 $52. 499,1 $19. 500,0 $240. 000,0 $253. 687,8 $27. 000,0 $87. 750,0 $60. 750,0 $8. 437,5 $21. 000,3 $48. 750,0 $1. 041. 750,0 $629. 560,9 $252. 000,0 $110. 500,0 $76. 500,0 $12. 937,5 $104. 498,4 $73. 25,0 Gross Margin GS&A Operating Income % Gross Margin * Cost allocation slide 11 $253. 376,0 $172. 500,9 -$13. 687,8 $412. 189,1 $350. 000,0 $62. 189,1 22,31% 42,76% 19,71% -3,60% 12 Cost Allocation: • DM&DL: SQxSP Valves Prod. Units 7500 DM costs 16 DL costs 12. 35 Pumps 12500 20 16. 25 Flow Contr. 4000 22 13 • OH: Activities Set up hrs Machine hrs Receiving& control hrs Packaging & Shipment hrs Engeneering hrs Pr Units x DLhrs Mhrs+set up hrs(machine) (75’/60) x production runs (50’/60’) x #ship + (8’/60’) x pr. Units Eng hrs Valves 2850 3850 25 1. 033,33 60 Pumps 6250 6850 125 1750 240

Flow contr 1600 3900 281,25 700 600 Total hrs used 10700 14600 431,25 3483,33 900 Capacity Costs Production workers 32,5 Indirect workers 30 Machines 81,25 Engineers 22,5 13 Q3. b Product costs and profitability with new cost assignment ? old cost assignment DL cost DM cost Man OH cost (185%) Std Unit cost Target selling price Planned gross margin Actual selling price Actual Gross margin Actual gross margin% Valves Pumps $12,35 $16,25 $16,00 $20,00 $22,85 $30,06 $51,20 $66,31 $78,77 $102,02 35% 35% $79,00 $70,00 $27,80 $3,69 35% 5% Flow C $13,00 $22,00 $24,05 $59,05 $90,85 35% $95,00 $35,95 38% ? new cost assignment:

DL cost DM cost Man OH cost Std Unit cost Target selling price Planned gross margin Actual selling price Actual Gross margin Actual gross margin% Valves $12,35 $16,00 $16,87 $45,22 $78,77 43% $79,00 $33,78 43% Pumps $16,25 $20,00 $19,95 $56,20 $102,02 45% $70,00 $13,80 20% Flow C $13,00 $22,00 $63,42 $98,42 $90,85 -8% $95,00 -$3,42 -4% • • – Valves more profitable: 35%(old) vs (43%) No changes in expectations Lower cost allocated: less activities dedicated to their production(std products, large lots) Pumps No meet expectations, but still profitable 20% Lower cost allocated: less activities dedicated to their production (std products) – Flow controllers No profitable: -4% Higher cost: many activities and people used in their production Q3. B 14 • The shift is caused by the Time-driven ABC method: – Costs are allocated to product lines which absorb more costs: more detailed and long production process for flow controllers …….. 15 Q4. What actions should the management take to improve Sippican’s profitability? Flow Controllers • Flow controllers not profitable as expected $253. 87,8 $27. 000,0 $87. 750,0 $60. 750,0 $8. 437,5 $21. 000,3 $48. 750,0 • High setup costs (148000) compared to the other overheads TOH* Machine related expenses Setup labor Setup Machine R&P Control P&S Engeneering Potential solutions: – Impose a minimum quantity order to lower set up costs Gross margin -3,6 (how to convince customers to buy a minimum quantity? ) – Production process improvement, with lower set up times 16 Q&A