Product Gross Margin Calculation vs. Product Contribution Margin Calculation Assigning the overhead costs to the products shows how profitable the products are after deducting all cost. However, it is important to find the appropriate method of overhead cost allocation.
In Sippican’s case the traditional accounting method is used, which does not reflect the real resource usage of the different product lines. The correct method in this case would be to apply the time-driven ABC approach for cost allocation.
Such method apart from showing the actual profitability after all cost deductions also depicts the differences in resource usage rates between the products and, thus, allows for identification of cost drivers. A contribution margin approach provides only insight into the products profitability after variable cost deduction, but it does not show whether the profit of a particular product is still profitable after all cost deductions. This could lead to a false perception of product profitability. In addition, this approach could lead to wrong decision making in terms of pricing or expansion actions.
Moreover, with this approach it is not possible to identify any cost drivers. Thus, many profitability improvement opportunities might be lost. Moreover, in particular, in the Sippican’s case the overhead costs are not really fix. They are fix only in the short term but variable in the long term as with an increase in volume of the products or the number of various products more machines and labor are required. The correct term for such cost is step-fix cost. Thus, the overhead costs in this case are not really a period expense (only in the short term).
Thus, the volume of each product line does indirectly drive the overhead cost in the long term. Consequently, it is important to see how each product affects the overhead costs or, to say it the other way around, what amount of resources does a product use and how does it differ from to the usage rates other product lines. Therefore, the executives should definitely not abandon the overhead assignment to the products, but instead use a different accounting method. Practical Capacity and Capacity Cost Rates
From the information given in the Exhibits and in the text I have calculated the practical capacity and the capacity cost rates for the different resources. Table 1 summarizes the results. The practical capacity rates were calculated by multiplying the number of employees/machines with their respective total effective hours per month. The capacity cost rates were calculated by dividing the total monthly cost by the respective practical capacity to become the cost rate of the particular resource per hour. Table 1: Practical Capacities and Capacity Cost Rates Note: For exact calculations please see the attached excel file.
Cost and Profitability Based on Time-Driven ABC Approach Table 2 shows the revised costs and profits of Sippican Corporation when calculating those according to the time-driven ABC approach. Table 2: Cost and Profitability Based on Time-driven ABC Approach Note: Total machine expenses include the expenses for machine production runs and the expenses for machine setups. For exact calculations please see the attached excel file. The expenses in each category were calculated by multiplying the actual usage of the resource (taken from Exhibit 3 and Exhibit 4) by the respective capacity cost rate.
It can be inferred from the table that valves is the most profitable product line with a gross margin of 42. 8% and not of 35% as obtained by the traditional cost accounting system. The pumps have a gross margin of 19. 7% as opposed to 5% and the flow controllers have a negative gross margin of -3. 6% as opposed to a gross margin of 38% as calculated using the simple accounting method. These differences in the cost and the resulting profitability of the product lines arise from the fact that according to the time-driven ABC approach the cost are allocated to the product lines based on their real usage of the company’s resources.
In the simple accounting method the manufacturing cost were allocated as a percentage of direct labor cost at a rate of 185%. This method did not account for any specific cost arising from the complexity, diversity or other production related specifics of the product line. In contrary, the time-driven ABC approach does account for all the nuances of each product line. From the table can also be inferred that the practical capacity is not totally used since at the end there is a total of $28,288 of unused resources. Table 3 summarizes the capacity utilization of various resources.
Table 3: Capacity Utilization Rates Note: For exact calculations please see the attached excel file. The significant shift in cost and profitability of flow controllers can be mainly explained by the considerably higher engineering and setup expenses (machines and labor). The latter arises due to the higher component number (10) of the flow controllers (resulting in higher complexity) which leads to a higher number of production runs and, thus, raises the number of setup hours. The number of production runs is further increased by the on average small batch sizes (see Table 4).
Table 4: Average Batch Sizes for Production Runs and Shipments Note: For exact calculations please see the attached excel file. The time-driven ABC approach reveals that flow controllers use disproportionally higher amount of the company’s resources per unit (see Table 5). It can be derived from Table 5 that flow controllers have much higher per unit cost than other two product lines across all cost categories. According to the time-driven ABC approach the total manufacturing overhead per unit cost amounts to $63. 4 as opposed to $24. 055 as derived by the simple accounting system.
As already explained above, the high per unit cost for flow controllers across the categories are mostly due to on average small batch sizes. For the majority of activities (setup, receiving and production control, partially packaging and shipping) the costs occur independent from the volume, but they do depend on the number of batches. For these reason the total manufacturing overhead per unit cost for valves and pumps are lower than estimated via the traditional accounting method as in these product lines the average batch sizes in production runs as well as in shipments were very high (375/188 for valves and 125/125 for pumps).
Table 5: Cost per Unit Note: For exact calculations please see the attached excel file. Recommendations Flow Controllers Starting with flow controllers, there are two ways to deal with the negative gross margin. First way would be to keep on producing the flow controllers and increase the batch sizes and thereby reduce the setup- and shipping related cost. If the batch sizes for shipments and production were increased to 25 units, the gross margin would amounts to 8. 6% (see excel sheet for precise calculations).
To reach the target gross margin of 35% by only adjusting the batch sizes one would have to increase the batch sizes of both shipping and production to 190 units. In reality the increase in batch sizes can be implemented by either imposing a minimum order size or reducing the variety of the flow controllers (this would reduce the number of production runs and allow for higher batch sizes). The freed up capacity from these actions can be used to increase the overall volume of the product lines.
One could also try to reengineer the flow controllers to require fewer components which also would result in fewer production runs and, thus, fewer setup hours. Moreover, as the past price increase has proven the demand for flow controllers to be quit inelastic Sippican could further raise prices for flow controllers and drive up the contribution margin. In reality the price increase should be accompanied with a promotion campaign which emphasizes the superiority of Sippican’s flow controllers to prevent the potential market share losses from the price increase.
If the prices were to raise by 10% the resulting gross margin would account to 5. 8%. Moreover, one could also try to reducer the hours of engineering. Table 6 shows an example of gross margin effects of the various actions outlined above. The total effect on the gross margin when applying all these actions would amount to + 24. 2 % which results in a gross margin of 20. 6% (by deducting the current -3. 6%). This is just an example. Further margin increases could of course be realized by further improving the identified cost drivers (please see the excel file to see the gross margin effects if changing the discussed cost drivers).
Table 6: Gross Margin Effects of Various Actions Note: For exact calculations please see the attached excel file. Another way to deal with the negative gross margin of flow controllers would be to abandon the production of them completely and thereby reduce the fix cost (step-fix cost to be precise). Thus, abandoning the production of flow controllers would lead to high reduction in resources and thereby saved costs. However, such a measure could lead to negative indirect effects on the image of the company which, hitherto, could result in market share losses in other products.
Therefore, this method of dealing with negative gross margin of flow controllers is highly unfavorable. However, in instead of laying off the employees and reducing the number of leased machines one could use the freed up capacity from abandoning the flow controllers production line for other purposes, such as volume increase in other production lines or taking a new production line into the portfolio. Pumps and Valves To deal with the price pressure apparent in the pumps market Sippican could attempt to further increase the batch sizes in production and shipment.
In addition, by combining higher batch sizes with an increase in the volume of pumps Sippican could increase the revenues and additionally fully utilize its capacity. Similar improvements can be applied for valves. ——————————————– [ 1 ]. 2 3 Brem, Lisa (2002). Sippican Corporation (A). HBS Publishing. February. HBS Note # 9-100-055. p. 4. Exhibit 2 [ 4 ]. 5 Brem, Lisa (2002). Sippican Corporation (A). HBS Publishing. February. HBS Note # 9-100-055. p. 4. Exhibit 2