Outback Jack Pty Ltd is an Australia-based pump manufacturing company, whose operation consists of three production lines: R-pump, F-pump and S-pump. The profitability of the company turned bad during the past two years and thus the management is concerning about some changes over the operations. The managing director proposed three possible changes and required further analysis on the feasibility of these changes as well as the effects they may have on the company's operation.
This report was conducted to assist the manager for decision making purpose. It starts with the establishment of a product line contribution margin income statement, according to which, assessments on these changes were performed to demonstrate the results of each change. Certain accounting techniques were applied during the process. Cost-benefit test, for example, was used to determine whether the change could help the company out of the poor situation and also what actions to take in order to maximize the company's performance. All the proposed changes were discussed in details and some recommendations were provided on these issues. Breakeven analyses were then conducted to illustrate the company's minimum operating level, both before and after the changes were adopted. Furthermore, the company's current costing system was evaluated and a revised costing system was accordingly introduced to better describe the company's production costs. It was eventually concluded that the company should take join measures to improve its financial performance. That is, discontinue the unprofitable product line, the S-pump line, and relocate the resources to the product line with high contribution margin ratio, R-pump. Additional recommendations on management were briefly discussed at the end with the hope to instil new ideas in the management.
As a small pump manufacturing company in Australia, Outback Jack Pty Ltd suffered a loss in the second quarter of 2010 due to the unexpected price drop and increasing expenses during the past two years. Only one of its three product lines was profitable in this quarter. The management has to take measures to change the status quo and lead the company back to profit.
Seeing the situation, the managing director proposed three changes to current operations. To assist the managing director in making the appropriate decision, an analysis is conducted towards the company's current financial position as well as the costing system to identify the potential problems and figure out the possible solutions. A product line contribution margin income statement replaced the traditional one to offer the manager a more precise view on the company's cost structure and performance of each product line. Additionally, each course of act individually as well as combining as a whole operating plan is evaluated and compared to determine what actions should be taken by the management. Further discussion and recommendation is given to improve the company's costing system and operations.
2. Reporting Method
Current Reporting Method
The company is currently using the traditional method to report its financial statement even for the internal use. As generally known, expenses are classified according to their functions in the traditional income statement, such as cost of goods sold , wages, utility expense, administrative expenses, etc.
However, this type of income statement is more likely prepared for the external users rather than the internal users as the information given in it cannot be directly applied by the manager for planning, controlling or evaluation of the performance. More information has to be collected through other sources in order for the managers to do analysis on the company's operations. For instance, before the managers are able to conduct variance analysis, one of the widely applied techniques in the management, they have to reclassify the information on activity basis, thereby comparing the actual operating results with the budget for control purposes.
2.2 Contribution Margin Method
In contrast to the traditional income statement approach, the contribution margin income statement is better suited for the managers in operating activities. A product line contribution margin income statement of the company is prepared (as shown in table 1) to illustrate the structure and usefulness of this type of income statement.
It is apparent that the contribution margin income statement clearly states the information categorised on activity basis for different product lines. Compared to the traditional income statement, it highlights the behaviours of controllable costs and indicates each product lines contribution to the company's profit and indirect fixed costs. Therefore, it is a very useful tool for managers to improve the operation efficiency, make budgeting and strategic plans, control the costs and operations, as well as evaluate the profitability of each product line.
Analysis on Proposed Actions
The managing director suggested three changes to the current operations to improve the company's financial performance.
a) Discontinue the S-pump product line immediately until the problems are solved.
b) Do promotion on R-pump by increasing the quarterly advertising by $100,000 to increase the sales volume by 15%.
c) Cut half of the production of the F-pump line and decrease the advertising and promotion expenses on this line to $20,000 annually (i.e. $5,000 quarterly).
Based on the product line contribution margin income statement outlined above, the potential influences caused by the proposed actions on the income statement of each product line are analysed to figure out the right decision for the manager in this case. Assume general selling and administrative expenses are allocated to the product lines in proportion to the sales volume.
Cost-benefit Analysis of the Proposed Actions
First of all, cost-benefit analysis is conducted to illustrate the potential benefits and required costs in each action as well as in the strategy to take all three actions as a whole. By comparison of the cost-benefit relationships among these four strategies as shown in table 2 (See appendix 1 for detailed product line contribution margin income statements for each strategy), the best strategy would be selected consequently.
As shown in table 2 of all proposed strategies, strategy a, discontinuing S-pump, would generate the most benefit for the company. This is because the S-pump line had an initial contribution margin of zero, which implies that this line did not produce any profit for the company. Instead, it made the company suffer a big loss owing to its fixed cost. From another angle, the elimination of the S-pump line reduced the sales revenue to $2.5 million compared to the original $3.4 million, but the contribution margin remained the same and the fixed manufacturing costs declined as well. As a consequence, the net operating income increased to positive.
As for strategy b, the advertising cost was not covered by the revenue generated from the 15% increase in the sales volume and thus the situation became worse with a more negative income. It is interesting to note that strategy c led to the same net operating income as that in the initial situation. By cutting the production and advertising expenses of the F-pump line, both revenue and costs declined by the same amount and therefore the net operating income did not change. In addition, the combination strategy summed up the influences of the three strategies and increased the operating income as well, although not so much as the that in strategy a.
Elimination of S-pump
As discussed above, the company would be best off to discontinue the S-pump line since the elimination brought a dramatic increase in the company's profitability. Because the S-pump line has a contribution margin of zero, it can never make profit to the company. Additionally, it has no important link to the other two lines, which means that the elimination would not have significant impacts on the profitability of the other two lines.
Promotion on R-pump or F-pump
Assume the promotion was put on F-pump with an additional advertising expense of $100,000. If the sales volume increased as much as that of the R-pump in the proposed strategy b, then the net operating income of the company would be -$133,900, which was much worse than strategy b, even though they were both negative. A 53.9% increase in sales volume of F-pump is required to achieve the same results as in the case of putting promotion on R-pump. More precisely, if the management wished to turn the company's profitability into positive by this approach, an increase in sales volume of as high as 94.11% would be required. This seems irrational to happen. (See Appendix 2 for detailed computation)
Although the promotion on R-pump could get relatively better rewards, as discussed above, neither strategy could help the company out of the current situation.
Use of the Company's Capacity
A primary focus of management is that using the scare resources most efficiently to maximize the company's profit. In this case, the company has been operating at its full capacity for years but this does not necessarily mean that the company was making efficient use of its capacity.
As mentioned above, the S-pump line has a zero contribution margin and should be shut down accordingly. Assume the company's sales are not limited by demand but by the company's production. Then it would be reasonable to relocate the labour, raw materials (if possible) from the S-pump line to other product lines. If the relocation was feasible, the company's production would increase and thus the sales would be improved.
Assume the relocation is feasible in practice. If fully relocated to R-pump, the production would increase to 15,500 units. Otherwise, if fully relocated to F-pump, its production would rise to 24,700 units. Accordingly, the expected net operating income in both cases could be computed as shown in appendix 3. With the jump of sales volume, the net operating income in each case would be $601,000 and $325,000 respectively. It is also interesting to note that both lines would make profit if the resources of the S-pump line were fully relocated to the F-pump. Therefore, further information should be collected to determine whether this kind of relocation is possible.
4.1 Current Costing System
According to the stated information, the company's product costing system can be shown in the figure below (Figure 1).
The current costing system is a simple system, involving four types of direct costs and only two types of indirect costs. The general selling and administrative expenses are allocated in proportion to the sales volume of each production line. Allocation per unit is the same for each product.
Revised Costing System
Since the current costing system is not specific enough to provide accurate cost information for the management, a revision has to be conducted to get it improved. According to the evaluation results above, the costing system is modified in some aspects and the more detailed costing system is shown in Figure 2.
Unlike the current costing system, the improved one is a more sophisticated system which has multiple cost pools and cost drivers. This system covers all the relevant activities in the process of production. The costs are generally divided into five parts and then allocated to each product based on its contribution to the product. Allocation per unit depends on each product's use of cost drivers, not the same any more.
To develop such an elaborate costing system, further study must be conducted to determine the specific indirect cost allocation procedures, which is not covered in this report.
Breakeven analyses were conducted to identify the minimum operating levels under each situation. This also gave another view to the feasibility of each proposed strategy. Breakeven unit was computed in the predetermined five different situations under the current costing system (since the revised costing system has not been exactly established and the indirect cost allocation has not been specified) and the results are shown in table 3. Because the S-pump line has a zero contribution margin, the breakeven cannot be calculated.
It is crucial to understand that the breakeven analysis could get different results under different costing systems. Therefore, as we may discuss above, under the revised costing system, the breakeven analysis has to be redone because the indirect costs would be allocated on a different basis.
As seen from the computed results, in most cases, the R-pump line requires about one third of the minimum operating level of the F-pump line because it has relatively higher contribution margin per unit. So it is much easier for the R-pump line to make profit.
To summarise, instead of the traditional income statement, the company ought to adopt the product line contribution margin income statement in case of internal management and control use of the financial information because it provides a better views of the information essential for cost plan and control. As for the three proposed changes of the operations, it appears that action a took the dominant place among them but cautions have to be paid to this strategy because it does not make effective use of the company's capacity. In order to find out the minimum operating level required for each product line, breakeven analysis was performed and then profit could be estimated by comparison between the real sales and the breakeven volume. In addition, the current costing system was assessed, realising the existence of drawbacks. Therefore, a revised costing system was established but further development on the details has to be conducted to identify the indirect costs allocation.
As discussed above, the S-pump line should be discontinued immediately as it has a zero contribution margin. Alternatively, the resources that should have been utilised by S-pump line, such raw materials, labour, equipment and facilities, may be relocated to the other product lines to improve the efficiency of the use of the company's capacity. The management should do a further study on the feasibility of the relocation.
Once the revised costing system is finalised, it is strongly recommended that the management should do a new breakeven analysis based on this modified, more accurate and detailed costing system. This may lead to different results and therefore, different actions may be adopted by the management to maximize the company's profit.