In February 2015, Majdy I. was appointed as a Chief Executive Manager of the Manufacturing Company by
Question:
In February 2015, Majdy I. was appointed as a Chief Executive Manager of the Manufacturing Company by Mamoun N., President. Majdy had wide executive experience in the manufacturing sector with high level of experience in products similar to those of Mamoun's company. The appointment of Majdy resulted from management president of the company. The president had only four years’ experience with the company, and in early 2015 was 34 years old in which he exercised full control until he hired Majdy. Mamoun knew that during 2014 he had made several poor decisions and noted that morale of the organization had suffered, apparently through lack of confidence in him. When he received the income statement for 2014 (see Exhibit 1) showing a net loss of 688 during a good business year, he knew he needed help. He attracted Majdy from a competitor by offering a stock option incentive in addition to salary, knowing that Majdy wanted to acquire a financial competence for his retirement. The president came to a clear understanding that Majdy would explain the reasons for his decisions and thereby train the president for successful leadership upon Majdy’s retirement. Upon taking office in February 2015, Majdy decided against immediate major changes. Rather, he chose to analyze 2014 operations and to wait to see results for the first half of 2015. He instructed the accounting departments for 2014. In addition, he requested an explanation of the nature of the company’s costs including their expected future behavior.
RELEVANT INFORMATION ON INDUSTRY:
Mamoun Manufacturing Company made only three industrial products: A, B, and C. They were sold by the company’s sales force for use in the processes of other manufacturing companies. All of the sales force, on a salary basis, sold the three products but in varying proportions. The company sold throughout Jordan and was one of eight companies with similar products. Several of its competitors were larger and manufactured a larger variety of products than did Mamoun company. The dominant company was Sam company, which operated a branch plant in the company’s market area. Customarily, Sam Company announced prices annually, and the other producers followed that.
Price cutting was rare, and the only variance from quoted selling prices took the form of cash discounts. In the past, attempts at price cutting had followed a consistent pattern: all competitors met the price reduction, and the industry as a whole sold about the same quantity but at the lower prices. This continued until
Sam Company, with its strong financial position, again stabilized the situation following a general recognition of the failure of price-cutting. Furthermore, because sales were to industrial buyers and because the products of different manufacturers were very similar, Majdy was convinced that Mamoun's company could not individually raise prices without suffering substantial sales volume declines. During 2014, Mamoun’s share of industry sales was 12% for product A, 8% for product B, and 10% for product C. The industrywide quoted selling prices were $24.50, $25.80 and $27.50 per 100 kilograms of product, respectively.
MANUFACTURING STRATEGY:
Mamoun’s manufacturing strategy was based on producing each of the three products in its own facility complex within the total general factory complex. The three product factories were referred to as A factory, B factory, and C factory. Each of these product factories was horizontally integrated beginning with receiving and extending through raw material storage, production-process facilities, finished-product inventory, and shipping. In addition, each product factory had a dedicated direct labor force, which for accounting purposes included hourly workers, shift managers, and other manufacturing-related personnel assigned to each product factory. Indirect labor “floated” between product factories as needed. Typically, Mamoun’s manufacturing facilities operated below capacity.
COSTING SYSTEM:
Mamoun’s manufacturing Company maintained a simple cost system. It was used for strategic planning, product-line decisions, identifying manufacturing process-improvement opportunities profitability analysis, performance evaluation, cost control, and inventory valuation purposes. Management’s goal was to assign all of the company’s costs to each of the three products in a way that would lead to the most useful product costs for the cost system’s various managerial purposes. The cost system identified two categories of costs. The first category consisted of costs, such as material costs, that could be tied directly to the manufacture of specific products. All other costs were placed in the second category and referred as indirect costs (see Exhibit 2).
The cost system accumulated direct and indirect costs at the product-factory level before determining the individual product costs on a per unit basis. Since each of three products was sold in 100-kilograms bags, per unit costs were expressed in terms of 100 kilograms of finished product. The per unit cost was calculated by dividing the unit output into the respective product factory’s total cost. Total cost was the sum of the product factory’s direct costs plus allocated indirect costs less
an allocated other-income amount. Allocated indirect costs included the company’s interest cost related to bank loans.
Costs designed as direct costs were assigned directly to the product factory in which they were incurred. For example, the cost of materials used to manufacture product A in its factory and was charged directly to the A factory account. This material cost could be traced directly to A factory through material purchase and requisition orders. Indirect costs were allocated to the product factories using a variety of allocation methods. For example, the total company rent expense ($5,324,000) was allocated to each product factory based on its enclosed cubic space. Cubic space was selected as the allocation basis to capture the fact that the production process for each of the three products included enclosed scrubber towers that varied in height depending on the product produced. Using the cubic space as the allocation base, the total company rent was charged as shown in Figure A to each product factory.
Figure A:
Total Company Actual Rent Expense
$5,324,000
Allocation Basis (Cubic Space)
Allocated Rent to Factory A
$1,872,000
Allocated Rent to Factory B
$1,570,000
Allocated Rent to Factory C
$1,882,000
The allocated per 100-kilograms rent cost of each product was derived by dividing the unit output of each product factory into the respective product factory’s allocated rent. A standard (Target) cost system was introduced in early 2015. It was used to value inventories, prepare budgets, and analyze performance (see Exhibit 4). Next year’s standard costs were last year’s actual per unit costs adjusted for anticipated cost changes. Since Mamoun’s three products were each sold in 100-kilogram bags, per unit standards were expressed in terms of 100 kilograms of finished product.
DROP PRODUCT C:
To Familiarize Mamoun with his methods, Majdy sent copies of Exhibits 2 & 3 to Mamoun, and they discussed them. Mamoun stated that he thought product C should be dropped immediately, as it would be impossible to lower expenses on product C as much as $2.16 per 100 kilograms. In addition, he stressed the need for economies on product B. Majdy relied on the authority arrangement Mamoun had agreed to earlier and continued production of the three products.
SEMI-ANNUAL RESULTS:
In the first week of July 2015, Majdy received from the accounting department the six months’ statement of cumulative standard costs including variances of total company actual costs from standard (see Exhibit 4). It showed that the first half of 2015 had been a successful period.
In order to expedite the availability of interim-period results, the company did not determine actual product-line revenues, costs, and profits. Rather, product-line data was prepared using standard per unit data and actual unit sales.
REDUCE THE PRICE OF PRODUCT A:
During the latter half of 2015, the sales of the entire industry weakened. Even though Mamoun manufacturing company retained its share of the market, its profit for the last six months was expected to be small. In November 2015, Sam Company announced a price reduction as of January 1, 2016 on product A from $24.50 to $22.50 per 100 kilograms. This created a pricing problem for all its competitors. Majdy forecast that if the company held to the $24.50 price during the first 6 months of 2016, the company’s unit sales would be $750,000. He felt that if we drop the price to $22.50, the six months’ unit volume would be 1 million. Majdy knew that competing companies anticipated a further decline in activity. He thought a general decline in prices of all products was quite probable.
The accounting department reported that the standard costs in use would probably apply during 2016, with two exceptions: materials and supplies would be about 5% below the 2015 standard. Majdy and Mamoun discussed the pricing problem. Mamoun observed that even with the anticipated decline in material and supply costs, a sales price of $22.50 would be below cost. Mamoun therefore wanted the $24.50 price to be continued, since he felt the company could not be profitable while selling a key product below cost.
CASE QUESTIONS:
1. Based on the 2014 income statement (Exhibits 1 & 2), do you agree with Majdy's decision to keep product C? Why?
2. Should Mamoun Company lower as of January 1, 2016 its price of product A? To what price and why?
3. Why did Mamoun company improve profitability during the period January 1 to June 30, 2015? How useful was the data in Exhibit 4 for the purpose of this analysis?
4. Why is it important that Mamoun company has an effective cost system? What is your overall appraisal of the company’s cost system and its use in reports to management? List the strengths and weaknesses of this system and its related reports for the purposes management uses the system’s output. What recommendations, if any, would you make to Majdy regarding the company’s cost accounting system and its related reports?
Exhibit 1 income statement for year ending December 31, 2014 (in thousands)
Gross sales $105,905
Cash Discount (1,567)
Net Sales $104,338
Cost of Manufacturing (65,251)
Gross profit $39,087
Less: Selling Expense $18,383
General Administration 6,534
Depreciation 13,591 (38,508)
Operating Profit $579
Plus: Other Income 205
Net Profit before Interest $784
Less: Interest (1,472)
Net Income ($688)
Exhibit 2 Analysis of income statement by products and departments-Year ended December 31, 2014 (thousands $ except per 100 Kilograms.)
Exhibit 3: Accounting Department’s Commentary on Costs Direct Labor: Variable. Union shop at going community rates. No abnormal demands foreseen. It may be assumed that direct labor dollars are an adequate measure of capacity utilization. Compensation Insurance: Variable. Five percent of direct and indirect labor is an accurate estimate. Materials: Variable. Exhibit 2 figures are accurate. Includes waste allowances. Purchase are at market prices. Power: Variable. Rates are fixed. Use varies with activity. Averages per Exhibit 2 are accurate. Supplies: Variable. Exhibit 2 figures are accurate. Supplies bought at market prices. Repairs: Variable. Varies as volume changes within normal operation range. Lower and upper limits are fixed. General Administrative, Selling Expense, Indirect Labor, Interest, and Other income: These items are almost non-variable. They can be changed, of course, by management decision. Cash Discount: Almost non-variable. Average cash discount taker are consistent from year to year. Percentages in Exhibit 2 are accurate. Light and Heat: Almost non-variable. Heat varies slightly with fuel cost changes. Light a fixed item regardless of level of production. Property Taxes: Almost non-variable. Under the lease terms superior pays the taxes; assessed valuations have been constant; the rate has risen slowly. Any change in the near future will be small and independent of production volume. Rent: Non-variable. Lease has 12 years to run Building service: Non-variable. At normal business level, variances are small. Property Insurance: Non-variable. Three-year policy with fixed premium. Depreciation: Non-variable. Fixed dollar total.
Exhibit 4 Income statement by products and departments at standard and total company variances from January 1 to June 30, 2015
(Thousands $ except per 100 kgs.)
:Instructions on how to analyze Case Study
General:
In the second page below, you will find a table that will help in analyzing the case.
Question 1:
After reading the case and relevant notes, students should go directly to Exhibit 2 where you can find sales and cost information related to three products. Where CM can be determined for A, B, C. Then you need to identify profit margin per unit then check if dropping will save fixed costs and check the CM. Then check, what consequences on the long-term can affect the company if you decide to drop or keep and recommend what to do.
Question 2:
Students should analyze the difference between the product actual and standard information by focusing on two major aspects price and variable cost. Then students need to identify if reducing product price what will happen to total CM.
Students can also check company's marketing efforts and the reflection on total contribution margin.
Question 3:
Students should list the reasons why the company's profitability increased during the first half of 2015. Give special focus on product B and the fixed costs of the company. Also compare the standard and actual variable and fixed costs (half of 2014 and the first half of 2015) for all products and contribution margin for products money and quantities. In order to do so, you need to prepare:
1. CM per unit (per 100 kilogram) for the 3 products in 2014 (half year).
2. CM per unit (per 100 kilogram) for the 3 products in 2015.
3. Analyzing the variance (the difference) between 2014 (half year) and 2015.
Question 4:
After the previous analysis on the costing system of the company, Students are required to identify case related-issues on:
1. The capacity of the company and the effect on cost.
2. What information you can provide the company on the variance in the variable costs in exhibit 4.
3. Evaluate the allocation base of the company with suggestions.
4. Analyze the selling expenses with your comments and feedback.
5. After identifying disadvantages of the current costing system, is there any positive features about the current costing system.
No calculations are required for this question.
Expert Answer:
1 Based on the 2014 income statement Exhibits 1 2 do you agree with Majdys decision to keep product C Why Based on the 2014 income statement I agree with Majdys decision to keep product C The gross ma... View the full answer
