Words: 2827
Rubber Group is the largest of the three operating units of Polysar Limited. The primary users of its products, such as butyl and halobutyl, are manufacturers of automobile tires; other users are from various industries. In 1986, Rubber group contributed 0. 8 billion which is 46 percent of the company annual sale. The operation of the group is divided into four divisions, NASA (North America and South America) and EROW (Europe and rest of the world), Research department and Global Marketing department.
NASA and EROW operate as profit centers each produce butyl and halobutyl dedicated to regional customers. Both of the centers have relatively flexible producing schedule to satisfy the increasing demand of halobutyl. After establishing the second plant in Sarnia, NASA is able to have each plant producing halobutyl and regular butyl. EROW, which has been running near capacity since 1980, solely focus on the production of halobutyl. Any idle capacity is utilized in manufacturing butyl. FINANCIAL PERFORMANCE ANALYSIS In 1986, Rubber NASA achieved a sale of approx. 6million which was 4. 8million higher than the budget. However, when came down to bottom line (net contribution), the division ended up a loss of 876thousand. This was 2. 8million lower than expected. Comparatively, EROW did well in all aspects with a sale of 89million and a net profit of 22. 6million. Why did the two divisions with same products have such a difference? After further exam, management concluded the large fixed cost absorbed sale figure. First it is important to understand the standard costing system implemented in Rubber group.
Standard costing assigns quantity and price standards to each component of variable and fixed costs in calculating the total cost. In the case of NASA, the system uses standard purchasing price (input cost) and standard inputs usage in place for variable costs, and standard spending price (input cost) and standard production (demonstrated capacity) for fixed costs. In each accounting period, a purchase price variance and an efficiency variance will be calculated to find the change in price and usage of the variable inputs (see Appendix I). In 1986, NASA incurred more variable cost than expected by844thousand.
However, the nature of variable cost is that it accumulates for each additional unit used in the production. Because of the sale growth, more inputs were applied into production. Again, the incremental cost was about 4% of the standard; hence the budgeting on variable cost was fairly accurate. Fixed Cost Management wanted to focus on the fixed cost as it turned a favourable gross margin (pre-fixed cost) to an underperformed gross profit (after-fixed cost). Fixed costs were composed by direct costs, allocated cash costs and allocated non-cash costs, including direct labour, maintenance, plant management, and depreciation etc.
Management finds two things after evaluation. First, the management noticed that fixed cost took a large portion of the total cost as it included many mandatory costs in daily operating and maintaining for a manufacturer. Additionally, direct labour cost was also calculated into fixed cost because the staff number had always been stable through the years. Second, fixed cost is sunk cost that doesn’t change with amount of production within capacity. In EROW, fixed cost was allocated to the production of butyl and halobutyl because two lines shared one capacity.
This was different from NASA who dedicated each plant on each product (Sarnia2 on butyl). As that being said, management realized that NASA would naturally incur more fixed cost on regular butyl than their counterpart which only used 50% capacity on butyl. Moreover, EROW required 12. 2thousand butyl from NASA as its production couldn’t meet the demand in Europe. The revenue were then recorded into EROW’s when the transfers were sold. If one incurred full cost while the other incurred half of the cost, it wouldn’t be a surprise to see a difference in the end.
Volume Variance Management had difficulties in communicating the two variances to its senior managers, volume variance mostly. The calculation of the two variances started with the standard fixed cost per tonne which was derived by following formula: Standard fixed cost/tonne =Estimated annual total fixed cost /Annual demonstrated plant capacity This year, the NASA Rubber’s estimated annual total fixed cost was 44,625,000, and the annual demonstrated plant capacity was 85000tonnes. Thus, the standard fixed cost per tonne for 1986 was 525/tonne.
Then, spending variance was calculated by, Spending Variance=Actual fixed cost—Standard fixed cost Actual fixed cost/tonne=Actual annual total fixed cost /Annual demonstrated capacity NASA had a favourable spending variance of 498thousand this year which means they spend 498thousand less than budgeted. The actual fixed cost per unit was around 519/tonne. Volume variance was calculated by, Volume variance= (Standard fixed cost/tonne) x ([Actual production]-[Demonstrated capacity]) NASA had an unfavourable volume variance of 11. 4million which was 5million higher than expected.
As shown above, volume variance was derived by multiplying standard fixed cost/tonne with the difference between actual production and standard production. By reorganizing the formula, it became: Volume Variance= Standard fixed cost/tonne x Annual total production—Estimated annual total fixed cost Simply speaking, the variance measures the amount of designated fixed cost not been absorbed into the actual production. The difference between actual production and standard production is also an indicator of capacity usage (efficiency) of Sarnia2.
Having a negative figure means the production is below demonstrated capacity. Demonstrated capacity (85thousand tonnes) would be the tonnes when all the standard cost was absorbed in production; thus, the best way to eliminate the variance is to produce close to the number. However, from the Statistics and Analyses, the management only expected to produce around 55 thousand and transfer 19. 5thousand to EROW. This was way less than the standard, not to mention the actual production was even lower. Accordingly this created a material difference of 5. 25million on volume variance.
Why did the management decide to allocate that much cost while not expecting to absorb all of them? This could be from the accounting issue that management didn’t have a sound system to correctly predict the sale, and production. Although management foresaw a growth trend, aiming to run the production at demonstrated capacity was too optimistic. Additionally, management always had the challenge of how to utilize sunk cost effectively, hence expecting production based on the capacity of sunk cost wouldn’t be an unusual practice. However, there could be more of an issue of strategy than an accounting issue.
STRATEGY ANALYSIS Rubber Group’s business strategy is to providing unmatched value (low cost, high quality, and regional service) to its customers so as to distinguish itself from its competitors. Three risks regarding current strategy is discussed. Competitive Risk Major competitors of Rubber are Goodyear, Bayer, Exxon and Dupont, and the market structure is fairly stable. The competitive risks mainly come from the supply side. The competition will increase the price of raw materials. The company may have to increase its prices or reduce its margin to compensate for the increase in the price of inputs.
As a result, customers may switch for cheaper suppliers. This will downsize the use of the capacity. Net contribution margin will be directly hurt by purchasing price variance and be potentially jeopardized by fixed cost variance. As mentioned above, a small loss in capacity will create great loss. Asset Impairment Risk Asset impairment exists when there are large inventories in the warehouses and may end up loosing significant financial value. Rubber group’s raw materials are determined by the industrial standards in those regions. For example, EROW uses different feedstock from NASA.
Were there a change in standards, the work in process and finished goods will likely loose market value. Depreciation is also a big concern for the machinery industry. In the case of Rubber NASA, one of plant was owned in 1942. Hence, a quick depreciation of this facility would be expected; at the same time, management should expect an incrementing maintenance cost. Operational Risk In light of current strategy, Rubber group possesses high operational risk as a result of machine downtime or the production of defective and faulty products.
It is easy to understand that faulty products hurt the reputation and cause customer dissatisfaction. Machine downtime, is the stroke to manufacturers. EROW has a bigger risk in this case as it has a single plant running at capacity. Were it happen, half of Rubber’s production will be paralyzed and they have to eat up the fixed cost. Though employ moral hasn’t been discussed in the case, the management should be cautious about the conflicts between employees and employers. In NASA, employees don’t seem to share the worry of being laid off as the number of staff is relatively stable for its computerized production line.
This may create certain loyalty among employees. However, the company’s compensation combined a below-industry salary with a bones tied to financial performance. Under the unfavourable financial situation, NASA’s management was certainly dealing with employees at a risk. Franchise Risk The manufacturing of rubber related products raise people’s concern on social externalities. In 1997, Kyoto agreement caused various standards on green house emission for various industries. Polysar would have to adjust its code of conduct to satisfy the government’s regulation.
Otherwise, the reputation of the company would be ruined, and the plants could be required to close down. Transferring Goods The purpose of categorizing transferring goods as a strategic issue is to motivate management take a broader view instead of seeking ways of changing numbers solely. In 1986, two profit centers transferred 14300 tonnes of regular butyl to each other in order to meet the demand in their regions. NASA transferred out 12. 2thousand tonnes at fixed cost of 8. 5million and received 2. 1thousand tonnes with fixed cost of 1. 3million.
For calculation, the fixed cost of transferred out was deducted against the fixed cost of production in deriving fixed cost of sales, while cost of transfer in added the value to fixed cost of sale. In that sense, had NASA transferred out more, they would have a higher net contribution. Similarly, if NASA received more from EROW, they would have a lower net contribution. The rational of the system is that the transferred goods carry the fixed cost to the receiving party. When EROW received the butyl, the fixed cost portion of the butyl was automatically allocated to the total fixed cost of EROW.
Therefore, it wasn’t unreasonable to recognize revenue of the transfers at receiving party (fixed cost deduct against revenue). Nonetheless, the sending party had to bear the loss on variable cost and period cost as these two costs weren’t transferred out with the goods. Strategically, EROW constantly fell short in the production of butyl as they wanted to catch the growing trend of halobutyl. Looking at the demand in both regions, NASA sold around 35. 8thousand tonnes of butyl while EROW sold around 48thousand tonnes. Additionally, Europe region had the advantage in the cost of feedstock.
Between the two profit centers, EROW definitely was more competitive than NASA. Combining the accounting problem, it would be a better idea to set up the second plant (now Sarnia2) in Europe instead of Canada at the first place. SOLUTION ANALYSIS The solutions should address issues with accounting performance and sale strategy; especially these four issues: 1. Revenue recognition for transferring products 2. Effective standard costing 3. Effective product scheduling 4. Future competitive plan Accounting Performance: Regarding the transferring products, there are actually two alternatives: Alternative 1: Cost side
Receiving party should account the total cost of transferred goods, which includes allocated fixed cost, variable cost and allocated period cost of the products. This is an approach to avoid the sending party eat up the variable cost and period cost, while the receiving party enjoy the mark up between sale price and fixed cost. This approach certainly provides advantage of reducing the burden of the sending party who would enjoy more Gross Margin after the change. The disadvantage of the approach would be the complexity.
As the price and type of feedstock in the two profit centers were different, it would be difficult to integrate variable cost easily into the receiving party. Alternative 2: The sending party should recognize partial of the revenue of transferring goods. As Mr. Choquette mentioned that not recognizing the revenue hurt NASA a lot and they couldn’t afford to not take the orders from EROW as they wanted to keep the volume variance up. Thus, having the sending party realize the variable cost portion of the revenue would generate more revenue for the sending party.
Moreover, the approach created better transparency as all inter-company sales would be shown as sale, instead of burying in the sunk costs. It also provides better understanding among managers. The approach also had the problem with complexity. The main purpose of the solution to standard costing is to create a more accurate bar for standard volume. One alternative would be to set the standard production on the basis of the production of past three years. If there is a growing trend, NASA can allocate weight to each of the three years. For example, 1986 standard production= 0. 5×1985 actual production + 0. x1984 actual production + 0. 2×1983 actual production For example, the standard volume in 1986 would be slightly higher than 65thousand tonnes(1985 actual production). In this way, NASA will have a more realistic standard volume to measure the production performance. The existing volume standard didn’t motivate employees to achieve. There was no point to set the standard when the management knew they wouldn’t accomplish. The alternative will provide NASA more realistic and achievable goal for its production. The disadvantage is still the sunk cost that NASA spent on running the plant.
Doesn’t matter which level they are producing, the machines depreciate at same manner. Also, if the company wants to cut fixed cost, they would most likely to cut the direct labour. This came back to the employee moral issue that has been discussed. The Alternative on product scheduling would be to have NASA produce at demonstrated capacity. The idea of relevant costing also supported the thought. NASA would be better off to produce the butyl themselves instead of transferring from EROW as they had extra capacity. What took to product extra products within capacity would be only variable cost.
If NASA transferred goods from EROW, they would have to take much more fixed cost from EROW. Every year, the group had to estimate the production based on estimated sale. As EROW usually operated at capacity, the practice became solely for NASA to project how much EROW would need next year. Having the profit centers individually decide the budget would create a goal congruence issue since the management of each center would act on their own interest. From Schedule of Regular butyl shipments from NASA to EROW, EROW became more dependent on NASA for butyl and shifted its focus to halobutyl. Having NASA roducing at full capacity will theoretically absorb all the fixed cost; at the same time, they won’t have to transfer butyls from EROW. However, the ideal has the downfall that it’s hard to achieve. And the unsold butyl will add up the value of depreciation. Sometimes, the inter-company transfers are just necessary because certain customers need the type of products from EROW. The best way is too find have a clear communication of the two centers and find the balance between them. Generally, the Rubber was doing well as they caught the trend of halobutyl and altered the production accordingly.
The Global marketing and R&D departments did well which reflect on the growth in sales. Here are two alternatives the company may consider: One, the company can setup a distribution department (central hub) which dedicated to distribute the products. All the products send to customers from the central hub. This will eliminate the inter-company transfers and kept the accounting for each profit centers easy. Additionally, the department will act as a customer representative of the company and respond to the customers faster than the plants. The method has the downfall of increased delivery cost and capital cost.
Two, the company can gradually let Sarnia2 take all the production of regular butyl and let EROW solely focus on halobutyl. As the cost of delivering was much cheaper than the cost of production, NASA could be beneficial by operating at a higher volume and delivering the product to the customer themselves. The method has the downfall of creating lags in responding customers in different regions. Also, once Sarnia2 breaks down, the whole business of butyl to Polysar will be paralyzed. CONCLUSION: Upon discuss, accounting method adjustment would only be good for short term goal.
Of the two alternatives, partial revenue recognition would be better for the sake of understandability. Regarding the volume variance, the company should take a strategic remedy such as fully utilize Sania2’s capacity by shifting production focus. In the long run, Polysar should seek cheaper resources in producing the products. With the trend of outsourcing, Polysar could definitely let third party take care of its non-core production. Alternatively, opening new plants in areas with cost advantage (Asia for example. ) would make the company more competitive.