Individual Paper: Activity-Based Costing

Matija Karaula





Individual Paper: Activity-Based Costing

Sippican Corporation















Course: B2B Pricing: Negotiation, Calculation, and Strategy


Matija Karaula
B2B Pricing: Negotiation, Calculation, and Strategy

Individual Paper: Activity-Based Costing

1) Defining the problem
The main problem of a Sippican corporation was a low pre-tax operating income (1.8%). To
solve that problem, a cause had to be found. Sippican reported gross margins of 35% on valves,
5% on pumps and 38% on flow controllers. After looking at a gross margins of the three product
lines, one would think that pumps were an issue to work on, and a main cause for a low
operating income, because the pump sales accounted for 47,36% of a total sales in March with
just 5% operating margin. However, the method of measuring the product profitability had to
be questioned. To be more accurate, the method of assigning the overhead costs to each product
line was the reason for inaccurate gross margins of the Sippicans product lines.
The method of calculating the manufacturing overhead used by Sippican would be accurate if
every of their three product lines was of the same or similar complexity. More complex
products require more indirect work so one cannot simply assign the overhead costs to the
products proportionally to direct labor working hours on each of them. However, that was
exactly what Sippican was doing and what resulted in overvaluing the flow controllers (the
most complex product line of Sippican), and undervaluing the pumps and valves. Moreover,
that created the wrong image of Sippicans product profitability which led to an inappropriate
pricing strategy.
2) Overhead assignment to products entirely or a contribution margin approach?
It is obvious that overhead assignment to products entirely is very inaccurate in this particular
case and that executives should abandon it, but the question is should they replace it with a
method which is even more simple and which does not even include overhead costs in
measuring the product profitability? The answer is yes, because by not including the overhead
costs in the product profitability, executives will not get a wrong idea on which pricing strategy
to impose. They would be just deducting direct costs from sales so they would not be getting
the wrong picture of overhead costs. For example, by using the overhead assignment to
products entirely, the following happens:
If the executives take a look at the gross margins calculated with the overhead costs
assignment to products entirely (the figures at the top of exhibit 2), they will get an
impression that pumps have a really low margin, and that there is no more space for
their price decrease, even though competitors are constantly decreasing prices. So
executives will get under a lot of pressure and probably make a wrong strategic move.
Wrong assignment of overhead
costs
Innacurate product
profitability
Inappropriate product
pricing strategy
Lower operating income
Exhibit 1 Result of a wrong overhead cost assignment
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Individual Paper: Activity-Based Costing

On the other hand, when they take a look at a contribution margin, they cannot get a
wrong picture (just an incomplete one) because one cannot get a lot of information from
looking just at the contribution margin (and the range of those figures is low so. So at
least they wont make a wrong choice because of the wrong picture of product
profitability. Contribution margin approach is simpler and the picture is incomplete but
at least it is not wrong.
Exhibit 2 - Product profitability by contribution approach and by gross margins






To conclude, it is better not to include overhead costs, then to include them and get the
completely different picture of the real product profitability. Both methods are inaccurate but
the latter is less inaccurate and simpler so that is the reason to adopt the contribution margin
approach in which manufacturing overhead is treated as a period expense. The best way would
be to use the time driven ABC method but if one is left to choose between the two choices
offered, than the contribution margin approach would be better.
3) Practical capacity and capacity cost rate
Exhibit 3 - Practical capacity
1
and capacity cost rates
2

Workers/machines
Shifts per
day
Productive
working
hours
Working
days
Practical
capacity
(hours)
Overhead
expenses
(March
2006)
Cost per
time unit
of
capacity
Production employees 45 2 6 20 10800 $351,000 $32.50
Setup employees 15 2 6 20 3600 $117,000 $32.50
Machine 62 2 6 20 14880 $334,800 $22.50
Receiving and production control 2 2 6.5 20 520 $15,600 $30.00
Engineering 8 1 6 20 960 $78,000 $81.25
Shipping and packaging employees 14 2 6.5 20 3640 $109,200 $30.00
1
Receiving, production, shipping and packaging employees have a little bit more productive hours per day (6.5)
then a production and setup employees (6) because they do not spend extra 30 minutes on preventive
maintenance and minor repairs.
2
Capacity cost rates were calculated by dividing the expense of each cost driver by its practical capacity in
hours per month, so the cost per time unit of capacity represented the hourly cost of Sippicans overhead cost
drivers.
35%
43%
64%
5%
20%
48%
38%
-4%
63%
-10% 0% 10% 20% 30% 40% 50% 60% 70%
Flow Controllers Pumps Valves
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Individual Paper: Activity-Based Costing

4) Differences in costs and profitability and the cause of their shifts

Revised cost assignment revealed a big differences in product profitability. Gross margins were
significantly different after revision because of the overhead costs that were unevenly
distributed and flow controllers were the most responsible for such a huge difference between
the costs and profitability margins. The complexity of flow controllers resulted in revised
overhead costs of $63.42 per unit ($39.37, or 164% more than in previous calculations). Valves
and pumps costs were undervalued by 26% and 34%, respectively. The amount of setup hours
contributed the most to those high overhead costs. The problem was in following: for every
hour of setup performing, there was a cost for laborers ($32.5) as well as the cost for machines
($22.5), because machines could have been working instead of being idle. Exhibit 4 shows the
impact of flow controllers on the total overhead costs distribution.









The following categories were the main cost drivers of flow controllers:
1. Production runs the product needed a lot more runs per unit then the other two
because it consisted of lot more parts
2. Machines on setup for every unit produced, machine was working for 18 minutes,
and it was on setup for 40 minutes and 30 seconds
3. Setup labor because of the large amount of time to setup the machine for the
production, flow controllers were responsible for almost 80% of all setup costs
4. Engineers were spending more than 60% of their time just on flow controllers

In Exhibit 5, it is visible how very high overhead costs per unit of flow controllers caused a
change in product profitability after measuring them with an appropriate method. Flow
controllers actual gross margin was negative (-4%) and pumps had a gross margin of 20% (15
percentage points more than with previous analysis) so there was still a space for price decrease
in pumps if it becomes necessary to react to market pushing of prices.
Exhibit 4 - Manufacturing overhead costs distribution
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Individual Paper: Activity-Based Costing

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Exhibit 5 - Income statement with product profitability and cost analysis
Valves Pumps
Flow
Controllers Reported Practical
1. Sales $592,500 $875,000 $380,000 $1,847,500 $1,847,500
1. Sales (%) 32.07% 47.36% 20.57% 100.00%
2. Direct costs $212,625 $453,125 $140,000 $809,000 $805,750
*per unit $28.35 $36.25 $35.00
2.1. Direct Labor Expense $92,625 $203,125 $52,000 $351,000 $347,750
2.2. Direct Labor Expense (%) 26.39% 57.87% 14.81% 100.00%
2.3. Direct Materials Expense $120,000 $250,000 $88,000 $458,000 $458,000
2.4. Direct Materials Expense (%) 26.20% 54.59% 19.21% 100.00%
3. Contribution Margin (1-2) $379,875 $421,875 $240,000 $1,038,500 $1,041,750
3. Contribution Margin (%) 64.11% 48.21% 63.16% 56.21%
4. Manufacturing Overhead $126,500 $249,375 $253,688 $654,600 $629,563
*per unit $16.87 $19.95 $63.42
*Old manufacturing overhead
(@185%) $22.85 $30.06 $24.05
*Difference $5.98 $10.11 -$39.37
4.1. Machine expenses total $86,625 $154,125 $87,750 $334,800 $328,500
4.1.1. Machine-related expenses $84,375 $140,625 $27,000 $334,800 $252,000
4.1.2. Machine expense on setup $2,250 $13,500 $60,750 $76,500
4.2. Setup labor $3,250 $19,500 $87,750 $117,000 $110,500
4.3. Receiving and production control $750 $3,750 $8,438 $15,600 $12,938
4.4. Engineering $4,875 $19,500 $48,750 $78,000 $73,125
4.5. Packaging and shipping $31,000 $52,500 $21,000 $109,200 $104,500
5. Gross Margin
$253,375.0
0
$172,500.0
0 -$13,687.50
$383,900.0
0
$412,187.5
0
5. Revised gross Margin (%) 43% 20% -4% 21% 22%
*Gross margin before 35% 5% 38%
*Difference 8% 15% -42%
6. General, Selling & Administrative
Expenses
$350,000.0
0
$350,000.0
0
7. Operating Income (pre-tax) $33,900.00 $62,187.50
7. Operating Income (pre-tax) (%) 1.83% 3.37%
To conclude, shifts in costs and profitability were caused by practical capacity that could have
been utilized better. The actual capacity was lower than the practical so the costs could have
been lower if the workers and machines were more productive
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.
5) Actions to improve the company's profitability
Based on the revised figures, executives should take the following action plan:
a) Change the method of product profitability calculation - In the future, they should
implement the time driven ABC method and assign the overhead costs to products to
calculate the product profitability they should then decide on pricing and other strategies.
3
Revised manufacturing overhead per unit was calculated by using a time driven ABC method. First, every
figure from monthly production report (exhibit 4 in the case study) was expressed in time units and multiplied
by respective capacity cost rate to get the total overhead cost for each product line. Finally, total costs for each
product were divided by the products unit number.
4
For example, the manufacturing overhead in the income statement from March 2006 was $654,600, but if the
practical capacity was utilized, the costs would have been $629,563 so the company would save $25,038
Matija Karaula
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Individual Paper: Activity-Based Costing

b) Different pricing Based on the revised figures and facts from the case, it is clear that
executives should adopt a different pricing strategy for flow controllers.
Valves: revised margin is 43% it is a sign that valves are doing good and that the
prices should stay at the same level.
Pumps: 20% margin there is still space for further price reductions if necessary.
Executives should leave the prices at the same level and react to the market because
pumps act as a commodity so further reductions could cause an unnecessary price war.
Flow controllers: on a negative margin (-4%) previous price reductions did not result
in a demand decrease so executives should definitely raise the prices. Flow controllers
are highly complex and hard to produce, moreover, there are lot of different types of
them so there are probably not many competitors who could produce them. Therefore,
Sippican should aim for a margin of 30% at least and increase the prices to reach that.
So to reach a margin of 30%, prices should be set at $140 (price increase of 47%) on
the condition that demand stays at the same level (which is highly unlikely).
Challenge: Hard to predict the right price increase detailed market analysis is
necessary. Price volume compromise has to be respected by the price-volume
compromise analysis
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made, for 1% of price increase, the volume should not
decrease by more than 1.56% in order to achieve the same profitability at least.
However, if the volume decreases by less than 1.56%, profitability will rise
higher iso-profit line will be reached.
c) Develop an incentive program to workforce for higher productivity Executives
should organize the teaching of the workforce the basics of TDABC in order for them to
understand how to contribute their company. In return, a certain percentage (for example
30%) per every dollar saved should be offered as an increase in salary at the end of the
month.
Benefits: Better working atmosphere, satisfaction, higher motivation and a win-win
situation for executives and a workers.
Challenges: It is impossible to offer the perfectly fair incentive to every worker,
basically the total labor savings would be divided by the number of workers and a
certain percentage would be shared equally. That could cause unhappiness among
those who consider themselves more productive than others.
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Analysis was made using the following formula:

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