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Colin Drury, Management and Cost Accounting – Brunswick Plastics

Brunswick PlasticsProfessor Anthony Atkinson (University of Waterloo) and adapted by Professor John Shank(The Amos Tuck School of Business Administration Dartmouth College)

This case is reprinted from Cases in Cost Management , Shank, J.K, 1996, South Western PublishingCompany. The case was adapted by Professor John Shank, with permission from the author from an

earlier case written by Professor Anthony Atkinson under a grant from the Society of Management Accountants of Canada. The case was originally set in the mid-1980s.

In September of 2000 Michael Smith, Division Manager of Brunswick Plastics, faced an importantpricing decision on a major new bid opportunity. Michael knew that pricing too high meant losing a bidthat would employ currently unused capacity. On the other hand, pricing too low meant losses on the job. In the first two months after Michael arrived in November of 1998, the presses were running onlyabout 40 per cent of available machine hours. The division had recently lost two large contracts andwas struggling to find a solid market position. Michael had instituted a policy of ‘contribution marginpricing’ to restore profitability. He reasoned that the fixed costs were already in place and there washeavy excess capacity. Any orders that generated positive contribution would enhance bottom lineprofits. In two years, machine running time was up to almost 50 per cent of available machine hoursand the number of different products manufactured was up from 30 to 50.

The companyIn addition to the 50 different products BP was selling, it was also typically experimenting in the factorywith a few others at any given time. New product introductions seemed to Michael to be a key step infilling up the factory. Smith’s best estimate of sales for 2000 was $1 200 000 and he thought BP wouldagain be just above the break even level on profits. An estimated income statement for 2000 is shownin Exhibit 1. The division had 20 full-time employees. Since the factory was not unionised, the factoryemployment fluctuated monthly, based on demand. Factory employment had ranged between 13 and31 people in the past 2 ½ years. Through strict attention to quality control, and by aggressivelypromoting its products, BP products were specified by major customers and had become the industrystandard for quality.

BP sold its products in both domestic and US markets and faced a highly competitive environment.There were many injection moulding companies in eastern Canada and the northeastern part of theUSA. As a result, pricing was a key to success, both from the point of view of securing contracts, andfrom the point of view of profitability.

Manufacturing at EP was done in two different modes. Some of the high volume products weremanufactured to stock in long runs to minimize set-up costs and to maintain required inventory levels.However, for most products, production was in response to a specific order.

The costing environmentThere were five major injection moulding presses in use at BP. The machines were of varying agesand all experienced frequent down-time because of set-ups, raw material problems, regular repairs,and special repairs related to complex products or new product problems. The factory typicallyoperated 2 shifts a day, 5 days a week, but volume fluctuations also led sometimes to one shift orthree shift operations. There were four common stages involved in manufacturing a product: (1) set upof the production machine, (2) the production operation, (3) the assembly operation, and (4) thetesting operation. The set up, assembly, and the testing operations were labour-intensive. The labourcontent of the production operation varied widely from product to product.

In injection moulding, molten plastic is forced into a mould where it is ‘cured’. The curing processrequires cooling the mould, usually with water. Once the product has cured, the mould is opened andthe product is removed.




Some products were produced in stationary moulds that required little manual intervention. Water haspassed through these moulds during the curing cycle. At the completion of the curing cycle, themoulds were opened and the products ejected automatically. For these products, the direct labourcontent was minimal and the operation was machine-paced.

Other products were produced in removable moulds that required manual intervention. After the

plastic was injected, these moulds were removed from the moulding machine and placed into a vat ofwater for the curing cycle. At the completion of the curing cycle, the moulds were opened manuallyand the product removed. For these products, the direct labour content could be significant since theoperation was labour-paced.

The products also varied widely in terms of assembly and testing time required. On the one hand, thecompany manufactured pediatric syringes used in the care of premature infants. These syringesrequired extensive attention to quality control and a considerable amount of manual assembly in a‘clean room’. On the other hand, the company also manufactured wheel chocks that required only acursory inspection and no assembly. The other products produced by BP varied between these twoextremes.

In addition to the product costing complications caused by the wide mix of manufacturing, assembly

and testing requirements, there were difficulties caused by the machines. Typical of the industry, themachines used at BP differed widely in terms of their reliability and their performance when producingdifferent products. A machine problem meant that the machine would have to be stopped and reset.Because the machine stoppages were highly unpredictable, incorporating a normal or averagemachine failure cost into the product cost was difficult.

On the other hand, the materials, assembly and testing costs of most products were well understoodsince each of these costs could be measured with reasonable accuracy. Materials costs could beestimated by the weight of the final product since the materials in most defective products could bereused. The assembly and testing operations involved the use of machines that were both highlyreliable and labour-paced.

These difficulties and the costing issues were all on Michael’s mind as he considered the milk crate

contract.

The milk crate contractDairies in eastern Canada used plastic crates to ship milk cartons from the dairies to the stores. Theannual sales volume of milk crates in the local region was about 30 000 units. Dairies merged theirorders for crates through the Dairy Council in order to take maximum advantage of possible quantitydiscounts. Michael had been asked to submit a bid on an initial order of 150 000 units. It was clear inMichael’s mind that a successful initial bid would give BP a competitive advantage in future orders.

Michael felt that the successful bid price for these crates would be ‘$3.00 plus or minus ten cents’.Michael had been approached by the customer several times and felt that BP’s reputation for qualitywould ensure that a $3.00 bid would be successful. As a result, estimating the bid price was not themajor issue. The question to be resolved was whether or not, given its cost structure, $3.00 could

cover BP’s cost for producing this product.

Discussions with Walt Roberts and Larry Bobbit, BP’s technical and production supervisors,suggested that the machine cycle time to produce this product would be 50 seconds per unit. Theproduct would be produced in a stationary mould and would be automatically ejected at the rate of oneevery 50 seconds. As a result, Michael calculated that it would require 2083

1hours of machine running

time to fill the order. On the basis of his discussion with Walt Roberts, Michael expected that the rateof defective crates produced by this process would be negligible.

Following discussions with Larry Bobbit, Michael felt that during the machine cycle the time machineoperator would have sufficient time to trim the excess plastic (flash) off the previous crate that hadbeen made and stamp that crate with the particular dairy’s name.

1 (150 000 x 50)/3600

2 (2083/0.6)




Based on BP’s experience, which was comparable to the industry average , Michael calculated thatthe moulding machine would run for only 60 per cent of the time that it was scheduled for operation.The rest of the time that it was scheduled for operation the machine would be down for repair, set-upor maintenance.

Consequently, Michael estimated that it would require 34722

hours of scheduled machine time toachieve the required 2083 hours of machine operating time. Since the operator would be required formost of the repair time, all the set-up time, and all the maintenance time, an operator would have to bescheduled for each hour of scheduled machine time.

Michael decided that the production of the milk crates would be undertaken on BP’s 750 ton injectionmoulder. This would require that some of the production scheduled for that be rescheduled to othermachines. Because BP currently had excess capacity available on other machines, Michael felt thatthe new order would not require sacrificing any production of any other products.

The cost of the a production mould used to manufacture the milk crates would normally be $90 000.However, the Diary Council already owned a suitable mould which they had agreed to lend to thesuccessful bidder on the contract.

Each milk crate weighed 1.6 kilograms. Polyethelene would be used to produced the milk crate. Thecost of polyethylene was $1.07 per kilogram. Michael felt that plastic trimmed off crates, or plastic indefective crates, could be reprocessed at a minimal cost. Consequently, the cost of raw material percrate was estimated as $1.71.

3

Since the machine operators were paid $6.00 per hour (including benefits), the labour cost per cratewas computed at $0.14.

4

The materials cost to stamp the crates was estimated as $0.01 per side, yielding a total cost of $0.04per crate. In addition, a stamping machine costing $5000 would have to be acquired. The life of thissimple stamping machine was estimated as 10 years, at least.

The crates did not require packaging for shipping and the Dairy Council paid for shipment. Michaelestimated that the labour costs to load the crates on a truck at the factory door would be $0.02 percrate.

As a result of these calculations, Michael believed that the direct variable cost of producing the milkcrates would be $1.91 (1.71 + .14 + .04 + 02).

This still left the matter of the overhead associated with producing each milk crate. This issue hadbeen a source of continuing concern to Michael on almost every contract he negotiated. Michael knewthat a common ‘rule of thumb’ in his plant was to apply variable overhead to products at a rate of $13for each machine hour (running time). An industry rule of thumb was to estimate total variable cost asbeing 1.3 times the direct material and direct labour costs.

5

Some analysts also advocated looking at fixed, as well as variable, manufacturing overhead. Basedon a recent study of BP’s costs, the corporate controller estimated that, on average, selling price mustequal at least 2.33 times the sum of direct material and direct labour costs in order to earn averageindustry margins of 6 per cent (pre-tax) when operating at the industry average 90 per cent capacityutilization ratio (scheduled hours). Some comparative data on industry economics is summarized inExhibit 2.

3 1.6 x $1.07

4 (50/0.6) x (1/3600) x $6.00

5 One source of this data was the publication Financial and Operating Ratios, published by The Society of the

Plastics Industry, Inc. This survey indicated that the total of variable costs was, on average, about 74% of salesfor injection moulders. Since the sum of direct materials and direct labour costs was, on average, 57% of sales,

this implied that total variable costs were, on average, 1.3 times the sum of direct material and direct labour costs(74% = 1.3 x 57%).




Michael wondered about the accuracy of any of these approaches in general and, in particular, hewondered if any one was suitable in this situation. Michael looked at the ratio market price to the sumof direct material and direct labour cost for some of his more popular products and found that this ratiovaried from two to seven. As a result, he wondered what if anything, was the implication of the 2.33factor.

As a guide to understanding the relationship between direct costs (material and labour) and fixedmanufacturing overhead Michael developed the data that appears in Exhibit 3. The plant accountantadvised Michael that plant fixed manufacturing overhead did not include direct materials, direct labour,variable overhead or plant supervision (about $50 000 per year).

In addition to manufacturing costs, BP was incurring about $220 000 per year in Selling, General and Administrative (S, G, & A) expenses.

Michael was not sure how to use Exhibit 3 to help him assign overhead cost to the milk crate order.The results did seem to indicate that overhead was virtually unrelated to the level of output in thefactory. The results thus did seem to support ‘contribution margin pricing’ policy. Michael was stillunsure, however, as to how he should approach this large incremental order. He observed to the case

writer: ‘If I only knew my cost structure better, I would feel more confident about what I’m doing. Rightnow I feel that I am shooting in the dark’.

EXHIBIT 1

Estimated income statement (2000)

Given Sales $1200(1/2.33=43% of Sales) Direct materials plus direct labour (515)(15 000 x $13) Variable overhead (195) (16% of Sales)

Contribution margin (CM) 490

(205 + 220 + 50) Fixed overhead (475)(Just above break even) Profit before taxes $15

EXHIBIT 2

Industry economics

At ‘normal’ capacity(90% Utilization) At full capacity

Average BP Average BP

Sales 100% 100% 100% 100%DM + DL 57 43 57 43Variable overhead 17 16 17 16Fixed overhead 20 35 18 31.5Profit before taxes 6% 6% 8% 9.5%

When operating near capacity, BP shows up as the High CM/High fixed cost/high profit player. Butnote that the profit impact (Profit % of Sales) of BP’s apparent strategy only shows up near full

capacity. High volume is a key to high profit for BP.




EXHIBIT 3

Cost and activity data

Direct LabourIndirect labour Total Plant fixed

Hours (production, hours (set-up, machine manufacturingassembly, testing) repair, and hours (running overheadmaintenance) time) (PFMOH)

Year Month

January 1 679 1 305 1 885 3 536February 2 298 863 1 775 17 196March 3 785 991 1 800 13 462 April 2 646 1 287 1 643 4 194May 2 606 1 686 1 848 15 958

1998 June 2 661 1 505 1 274 7 644July 1 670 938 1 182 3 530

August 1 844 1 337 1 003 7 073September 1 839 1 343 1 351 6 094October 2 088 1 295 1 837 10 072November 2 330 1 743 1 533 4 173December 1 434 1 416 601 6 078

Total 26 880 15 709 18 321 99 010

January 1 694 1 019 1 104 3 811February 1 701 933 1 128 4 712March 2 103 1 532 917 11 325 April 1 756 1 192 1211 1 161May 2 184 1 276 1 249 6 572

1999 June 1 625 890 829 10 063July 1 775 1 256 1 278 7 621 August 2 007 1 728 1 095 11 028September 2 094 1 337 1 824 15 198October 2 178 1503 1 788 4 690November 2 992 1 868 1 471 9 484December 2 079 1 751 1 313 5 615

Total 24 188 16 290 15 207 91 280

January 2 714 1 922 1 899 18 293February 2 240 1 328 1 567 15 733

March 2 275 1 663 1 723 39 988 April 1 737 1 157 954 3 033May 1 547 1 443 654 9 358

2000 June 1 389 1 434 634 20 166July 2 394 1 948 1 735 16 308 August 990 856 1 005 14 267

Subtotal* 15 286 11 751 10 171 137 146

~23 000 ~17 500 ~15 000 ~205 000

*annualized for 2000 (12/8)




To explore the casual relationships reflected here, Michael developed the following four linearregressions:

R 2 t -Statistic

1. (PFMOH) versus Machine Hours (MH):

PFMOH=$3681 + ($4.86 x MH) 0.07 1.48

2. PFMOH versus Direct Labour Hours (DLH):PFMOH=$4321 + ($2.85 x DLH) 0.04 1.15

3. PFMOH versus Indirect Labour Hours (ILH): 0.07 1.49PFMOH=$1684 + ($6.25 x ILH)

4. PFMOH versus MH and DLH:PFMOH= -$79 + ($2.89 x MH) = ($1.87 x DLH) 0.09 0.70/0.81

Questions

1. Based on your interpretation of Exhibit 3, what is your estimate of the change in ‘PFMOH’ cost ifthe factory were to run one extra batch of 150 000 milk crates?

2. What is your estimate of the incremental cost per unit for one batch of 150 000 milk crates?3. What does Exhibit 2 suggest would be a ‘normal’ price for milk crates for an ‘average’ job shop?

What does this suggest about the $3.00 price which seems to prevail at the time of the case?4. What is the ‘strategically relevant’ cost per unit for milk crates (for purposes of deciding whether

or not the $3.00 ‘market price’ is profitable, on an ongoing basis)?5. What is your advise to Mr. Smith regarding the milk crate opportunity? Be specific and show the

calculations supporting your advice.6. What overall strategic advice do you have for Mr. Smith? Why isn’t the business doing better,

given the new ‘specialities strategy’ and good business conditions? Support your answer with

relevant cost analysis.

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