Anagene Inc.

Group Assignment
 Table of Contents
Executive Summary......................................................................................................................3
Background.................................................................................................................................4-7
Major Issue Identification.............................................................................................................7
Key Success Factors and Constraints.......................................................................................7-9
Alternative Generation and Analysis......................................................................................9-13
Sensitivity and What-If Analysis.......................................................................................... 13-15
Recommendation and Conclusion.........................................................................................15-16
Appendices: Calculations.......................................................................................................17-19

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Executive Summary

As expansion has been the main focus for Anagene Inc., continuous changes in an

emerging field has made it difficult to assess costs and give investors a clear insight on projected

sales. It is important to understand the nature of the external environment the company is

operating within. The genome field is relatively new and with many breakthrough technologies

entering the industry. However, the company has seen success, as it has leveraged

microelectronics in its microarray design. The company has found an opportunity in this new

niche market and has shifted its focus from research and development to manufacturing research

applications. The companys main operations are now narrowed down to their work stations and

cartridge sales. Even though future trends are forecasted to be optimistic, with large fluctuations

occurring and limited information on hand, the company is still feeling their way in the dark.

The main issue faced by Anagene Inc. is that the margins for cartridges have been

decreasing and standard costs have increased about 40%. Furthermore, since product costs have

been unpredictably fluctuating from month-to-month, gross margins have been fluctuating

accordingly, which makes it difficult to understand profitability. There are three alternative ways

to solve this problem. Firstly, Anagene Inc. can choose to not assign fixed overhead costs by

using the contribution margin approach. Moreover, they can assign fixed overhead costs per unit

based on budgeted production or practical capacity. After a thorough evaluation of the

alternatives, it is suggested that Anagene allocates its fixed overhead costs based on practical

capacity because the numerator in an activity cost driver rate calculation represents the costs of

supplying resource capacity to do work, therefore the denominator should represent the quantity

of work the resources can perform. This method stabilizes their gross margins as well as

increases their margins by charging a more accurate and representative price for the cartridges.

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Background

What is Anagene?

In 1993, Anagene was founded by Mark Hansen, PhD in biochemistry, and Harold

Bergman, a serial entrepreneur well known in the biotechnology field. Anagene is an established,

publicly exchanged bio tech company that focuses on genomics instruments, operating in an

emerging market.

Mission

Anagenes mission is to facilitate breakthrough genetic analysis. The process is run by a

Molecular Biology Workstation which consists of four cartridges that facilitates gene screening,

matching and analyzing. Due to wear and tear, the cartridges need to be replaced in order to

maintain test accuracy. The demand for the cartridge replacement has become Anagenes target

market.

Value Proposition

Anagenes sales teams main focus is to deliver solutions on customers toughest assays.

Anagenes First Major Product

Anagenes main product is the Molecular Biology Workstation. This workstation

includes a loader, a reader and a disposable cartridge that contains the companys proprietary

microchip. Tubes of DNA samples are examined on the microchip. Anagenes product focused

on patient-oriented genomics as the cartridge had been designed for low volume applications and

produced very accurate results. Anagene emphasizes on the accuracy of technology.

External Environment

The market of genomics is a wide spectrum. On one end there is industrial genomics:

large-scale sequencing, gene discovery work based on large populations and large volumes of

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data, where accuracy is vital but not necessary. On the other end, there is patient-focused

genomics, which is based on clinical research on individual genes, where tens of thousands of

patients may be analyzed. For patient-focused genomics, accuracy is the key to determine

efficacy and safety of drugs for individual patients. The market for DNA microarrays was large

and projected to grow to $4.5 billion by 2004. Market participants, such as Anagene, have

achieved revenue from two major sources: equipment sales and follow-on sales of chips or

cartridge. This market has demonstrated a large potential payoff, which acts as an incentive for

several companies to enter the DNA microarray market, thus increasing competition and

crowding the market. Despite this, industry analysts believe that Anagenes technical approach to

design and use microarrays is a competitive advantage. Unlike its competitors, Anagene

leveraged microelectronics in microarray design, giving users the ability to localize probes and

samples at specific predetermined sites. In addition, Anagenes product was considered

extremely accurate with several beta sites. Beyond this market, Anagene also began establishing

strategic relations and collaborations with other companies to gain access to global markets

without having to shift limited resources away from development and sales.

Stakeholders

1. Gerald Kelly, President and CFO of Anagene: Kelly is currently being questioned by the

Board for the 40% increase in standard costs for the companys main product line: Anagene

cartridges. Kelly must explore alternative methods for calculating product costs and gross

margins that would represent long-run performance. Kelly does not believe that Anagenes

business fundamentals changed radically from month to month, and will work with

Anagenes controller to look into the causes of fluctuating and unpredictable margins.

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2. Board: The board is seeing a problem persisting into the 2001 year: shifts in product costs

and gross margins are unpredictable (higher unit costs and reduced margins).

3. Investor community: the higher unit cost and reduced margins will be unattractive to

investors.

4. Industry analysts: They would examine Anagenes quarterly gross margins closely as they

built business models to predict future profits. Analysts wanted predictability for gross

margins.

5. Global relations: Anagene needs to be a predictable company to maintain strategic relations

and collaborations with global companies.

6. Customers: Customers use Anagenes disposable cartridges and work stations. Anagene

discovered that some customers were reusing disposable cartridges rather than ordering new

ones

7. Hitachi Ltd (Supplier): Anagene outsources to Hitachi for production of the loader and

reader components of workstation. Anagene plans to work with Hitachi to cut costs through

value engineering, and reduced transfer costs. There is a possibility that over time, Hitachi

will take over final quality control and ship directly to customers.

Qualitative Focus

Whichever alternative that Anagene chooses, they should continue on marketing the

importance of cartridges being non-reusable, as to increase sales. They should also work on

getting the support of top management in the new suggested recommendation to ensure support

and commitment to future budgeting and decision making. Finally, Anagene should make sure

that they advise shareholders and keep all stakeholders informed on this necessary action to

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ensure support and minimize any rebellion. This will increase a sense of ownership among

stakeholders as well as make the implementation of this necessary action run more smoothly.

Major Issue Identification

The major issue faced by Anagene Inc. lies in its standard cost calculation. Firstly,

cartridge margins have been decreasing and standard costs have increased about 40%, which

raises serious questions about the long-term profitability of the business. Secondly, since product

costs have been unpredictably fluctuating from month-to-month, gross margins have been

fluctuating accordingly, which makes it difficult for board members and analysts to understand

the short-term profitability. As a result, losses have been reported on Anagenes budgeted

income statement for the past few periods. Moreover, sales forecast was adjusted down by 24000

units, (50000 to 26000). Since the genetics market is growing rapidly and the number of

customers is greatly increasing, analysts find it difficult to project future sales, which pose a

problem for Anagene Inc. to evaluate their profitability under their standard cost estimation

method. Currently, Anagene uses projected demand as the basis for budgeted volume, which

greatly impacts the pricing and stability of gross margins as Anagenes sales fluctuate. As the

budgeted volume is volatile, allocated fixed overhead costs per unit and gross margin fluctuate in

the long run. Therefore, Anagene needs to calculate product costs and gross margins that would

be representative of long-run performance and to help management make better decisions.

Key Success Factors and Constraints

Market for DNA microarrays was dynamic and growing as participants generated large

volumes of revenues from sales of chips or cartridges. Although the market had many suppliers,

industry analysts believed that Anagenes technical approach to the design and use of

microarrays was innovative and effective. This gives Anagene a competitive advantage, which

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may allow it to charge a higher price. However, because Anagene does not have a monopoly and

the demand for its cartridges is elastic, it cannot charge a price too high to decrease demand

drastically, thus affecting sales and profitability of the business.

Moreover, unlike its competitors, Anagene leverages microelectronics in its microarray

design, as it gives users the ability to localize probes and samples at specific predetermined sites.

Anagene ships its cartridges without any DNA attached, which allows customers to put down

whatever they wanted to study. In contrast, most competitors sold their chips pre-spotted with

massive arrays of DNA, which gave Anagene further competitive advantage amongst

competitors or other suppliers.

Another strength is that Anagenes products are considered to be extremely accurate and

the accuracy has been proven by several beta sites. Moreover, Anagenes technical

representatives helped companies develop their most difficult assays. They also began to

establish strategic relationships to access global markets without having to shift its limited

resources away from development and into sales. Anagene also accelerated the use of non-title

transfers so that the companys technology could be adopted quickly across different markets,

providing a strong base for future cartridge sales. Due to these strengths, Anagene sold more

workstations, and as a result, expected the demand for cartridges to increase rapidly.

Despite the fact that Anagenes product has many competitive advantages, it fails at

allocating fixed overhead costs which creates an unstable trend for gross margins. The higher

unit cost and reduced margins would affect investor community since industry analysts would

examine Anagenes quarterly gross margins closely as they build business models to predict

future profits. Analysts expected predictability and Anagenes gross margins had not been

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predictable. This could potentially harm their products further as it would decrease the demand

for their products as well as sales

In 2001, forecasted sales had to be revised from 50,000 to 26,000 units because sales lead

time had been longer than originally estimated due to differences in the length of time required

by difficult assays. Also, rather than ordering new cartridges for each experiment, customers had

been reusing the disposable ones. Moreover, the ramp-up of workstation sales had been slower

than expected in 2000, which led the installed base to be smaller than projected. These serve to

be threats to Anagenes profitability.

Lastly, it is important to note that GAAP is not a constraint because these costs are being

used for internal decision-making.

Alternative Generation and Analysis

Qualitative and Quantitative (Internal, External, Financial)

Alternative 1: Do not assign fixed overhead costs at all or use contribution margin that only

takes variable costs into consideration

Overhead cost allocation is crucial because it affects gross margins and provides a more

accurate value of costs associated with the production of each product. Therefore, it is not

recommended to ignore fixed overhead costs as they affect the companys profitability and in the

long run, may force Anagene to discontinue production if great losses are incurred. Ignoring

fixed overhead would affect Anagenes pricing strategy as Anagene may set prices much lower

than the actual costs incurred, which would cause great losses. It also limits managers from

understanding the probability of idle capacity and does not allow them to make decisions

holistically as it constrains the production process. The variable contribution margin method

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would be most effective for Anagene if there was a short-term price change such as a special

order that would constitute a different price than current price of $150.

Alternative 2: Divide the allocated overhead costs by budgeted production/manufacturing

Fixed Overhead
volumes to obtain an overhead cost per unit [Overhead cost per unit = Budgeted Production]

Current way of allocating OH

Anagene Inc. is currently calculating its product costs by allocating overhead costs based

on budgeted production volumes. Since Anagene is in an emerging market, where sales vary

dramatically from month to month, forecasting sales is very difficult to do. Since the cost

depends on budgeted volume (sales forecast), a decrease in the sales forecast would cause

standard costs to increase as well as increase volatility in margins from month to month. Fixed

overhead costs per unit are currently updated only once a year, therefore, such aggregate and

infrequently updated information was not very useful for production cost control. The dynamic

market condition and limited information have raised standard costs by 40% and gross margins

to drop from 65% to 45%. This was because of the lower anticipated cartridge production

volumes of 26,000 as opposed to the 50,000 forecasted sales which caused the overhead cost per

cartridge to increase.

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 Lower actual sales cause a death spiral or vicious cycle which may be very harmful to the

business and its operations. If plant level overhead costs are fixed in the short-run and

management uses forecasted activity levels to calculate cost driver rates, activity cost drivers will

increase if activity level declines due to slowdown in economic activity or loss of a major

customer. As these costs are used for internal decision making, higher cost drivers may lead

management to set higher prices which in turn would reduce demand. Customers would search

for substitutes which would further decrease sales and lead to even lower activity levels. Lower

activity levels would then be used again to calculate cost driver rate, which would be even higher

in the next period.

The problem arises because Anagene Inc. has contracts and commitments to acquire

resources, which means that plant level overheads costs cannot be reduced in the short run in

response to lower activity levels, thus these costs are fixed. Furthermore, managers may want to

maintain the current level of resources in order to handle the higher-than-expected order volumes

in the future.

The only advantage of using this approach would be that it will allow Anagene to hide its

idle capacity as budgeted volume is based on demand instead of production capacity.

Alternative 3: Divide the allocated overhead costs by practical capacity to obtain overhead cost

Fixed Overhead
per unit [Overhead cost per unit = Practical Capacity]

Another alternative is to calculate the overhead costs per unit by dividing the allocated

overhead costs of cartridges by the practical capacity. Cost driver rates should reflect the

underlying efficiency of the process. This is done by better recognizing the capacity of the

resources being supplied. The numerator in an activity cost driver rate calculation represents the

costs of supplying resource capacity to do work and the denominator should represent the

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quantity of work the resources can perform. This will allow Anagene to reduce allocated fixed

overhead costs per unit, thereby increasing gross margins. Assuming that Anagenes full

practical capacity is stable in the long run, allocated fixed overhead costs per unit and gross

margin per unit will also be constant. Using the full practical capacity as the cost driver will

allow Anagene to lower its allocated overhead costs per unit, and increase the gross margin while

keeping current prices. This will allow them to maintain their demand as prices will not be

affected by fluctuating costs and maximize their profits. Moreover, using practical capacity will

also allow Anagene to manage production costs in a more efficient way by maintaining an

efficient budget as well as identifying constraints that affect the production process. This will

allow them to minimize idle capacity.

Practical Capacity method for

calculating OH

As seen above, using the practical capacity to allocate fixed overhead costs allows

Anagene to maintain higher gross margins compared to using budgeted volume. In the case of

Anagene, this seems to be a more appropriate way of allocating overhead costs because Anagene

is in an emerging market where demand constantly fluctuates and so do product costs and gross

margins. Practical capacity takes into consideration production levels in the long run, which is

more appropriate for estimating production levels. This alternative is essentially utilizing the pre-

determined overhead rate method. The estimated overhead amount is $1,299,581 and the rate is

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$25.33 per unit based on a practical capacity of 51,300 units. If Anagene sells fewer units than

this amount then the applied overhead cost will be greater than the actual overhead cost which

will result in a credit in the overhead cost account so that it equals actual overhead cost. The

opposite will happen if Anagene sells more than its practical capacity.

Due to the fact that Anagene expects future demand to grow as the cartridges will no

longer be reused, management will make use of practical capacity to do the sensitivity analysis,

identify idle capacity as well as set prices that are more representative. Current production

capacity level is only 51,300 units, but the forecasted sales for 2002 are 95,000 units. This means

that Anagene will have to stock up inventory to meet future demand. Therefore, using practical

capacity as the basis for allocating fixed overhead costs will allow Anagene to better manage

their business as they will be exposed to and will have a better point of view about stocking up

inventory to meet future demand.

The only downside of using this approach would be that it reveals the companys

operating potential.

Sensitivity and What-If Analysis

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 As seen in the income statements above, under various sales that do not exceed the

practical capacity (to make the comparison more simple), the practical capacity method

maintains a relatively constant gross margin of 62-63% but under the budgeted sales approach

method, the gross margins fluctuate widely. Anagene Inc. would benefit greatly by accurately

knowing what their gross margin will be as that will allow them to be more aware how many

units they need to sell to cover their fixed costs. As a result, they will know the magnitude of

their profits. This will also allow them to set appropriate prices as to ensure they are able to

cover their costs and are able to accomplish their objectives as a company.

By continuing on with the budgeted sales approach, there is too much unknown. Anagene

cannot accurately estimate their overhead cost per unit ahead of time as they are in an emerging

market, and therefore, cannot accurately estimate sales. This does not allow Anagene to set

representative prices, which has resulted in losses as they fail to cover their fixed costs. Under

these circumstances, Anagene would have to wait until the end of the fiscal period to know a

more accurate magnitude of fixed overhead incurred.

If Anagene Inc switches to the practical capacity approach, they will be able to determine

a more accurate overhead rate per unit ahead of time (or a POHR (pre-determined overhead rate))

which will allow them to estimate manufacturing overhead costs sooner. Then, at the end of the

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fiscal period, they can see whether their estimate was overapplied or underapplied and adjust the

overhead account accordingly as seen below.

**Assumption: $1,299,581 is the applied OH in this scenario

Under all of the different sales examples, the applied overhead cost was greater than the

actual overhead cost which resulted in an overapplied amount for overhead at the beginning. The

overapplied amount requires a credit in the overhead cost account, and a debit in the inventory

account so that the overhead cost equals the actual cost of overhead incurred in the fiscal period.

This also increases gross income as well as net income.

Recommendation and Conclusion

Anagene Inc. should calculate fixed overhead costs per unit based on practical capacity

instead of budgeted production. If Anagene Inc. continues using budgeted production to

calculate the fixed overhead costs per unit, they will fall into a spiral where they will have to

repeatedly increase prices to maintain their current margins, resulting in a decrease in demand.

Using practical capacity approach reduces allocated overhead costs, which will enable Anagene

Inc. to maintain a higher and more stable gross margin at current prices and in turn maintain

demand.

Anagene Inc. is a part of an emerging market which means that demand will fluctuate

from month to month. This makes using practical capacity as a cost driver beneficial since the

overhead cost per unit will be maintained at a constant level. Moreover, the practical capacity

method will indicate the idle time, which offers upper management better understanding about

the companys current performance and facilitates them to make future production plans.

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 In addition, practical capacity gives the company a better structured budget and enables

Anagene Inc. to look into constraints in production. If Anagene Inc. tries to keep profit margin

consistent with the previous year without reaching its full practical capacity, prices will be

increased, resulting in a decrease in demand. The sales forecast for 2002 is 95,000 but the current

practical capacity is only 51,300 as it is constrained by permeation layer deposition and thickness

testing. To increase practical capacity, Anagene aims to implement new production techniques

and machinery like the automatic spin coater. However, it is important to note that doing so will

be beneficial in the long run, but will not be relevant for the year 2002. In the future, if Anagene

plans to implement this technique, they may have to hire more employees. In that case, Anagene

may want to allocate fixed overhead on the basis of direct labour or direct labour hours.

In conclusion, Anagene Inc. should switch over to using practical capacity as it is in an

emerging market. Doing so will allow them to enhance production processes as management will

be able to identify constraints and minimize idle capacity. They will also be able to adopt a better

pricing strategy as they will be aware of truer costs of each product. This strategy is more likely

to attract investors which will be crucial for Anagene's future.

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Appendix A: Fixed Overhead Calculations

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Appendix B: Income Statement Calculations

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Appendix C: Income Statement (What-if and Sensitivity Analysis) Calculations

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