1. Contribution margin is a quick way to analyse company's profit.

Adopting the contribution

margin approach is very straightforward, since it is conducted with the information that has
already been calculated for other purposes. However, for multi-product companies, like
Sippican, it is impossible to analyse the gross margins for each product. For that reason, the
overhead assignment methods should be used.

Sippican had used traditional costs systems which led them to be able to easily see which all
products were more profitable, and accordingly take corresponding management decisions.
However, according to the current product offer by Sippican, it may not be the best to adopt
the overhead assignment method of traditional cost systems. Furthermore, using the method
activity-based costing (ABC), is often claimed to have a value-enhancing effect on pricing
decisions and profit performance (Kaplan and Atkinson 1998; Goebel et al. 1998) because they
allow better cost allocation among different products. Also, this system should be used in very
competitive markets mostly because it allows the company to reduce the prices, and to be
competitive without the risk of losing money (Gupta and King,1997).

Currently, Sippican sells valves & pumps as two of their standard products, and Flow
Controllers as their highly customised product. This implies that the overhead costs of Flow
Controllers will be diluted in the other two products, and the gross margin will be higher.
Moreover, since Sippicans competitors had trigged a price war in the Prump product line, it is
important for the company to analyse if they can match or even respond with lower prices than
their competitors, without losing money.
As such, it is recommended that Sippican should not abandon the overhead assignment to their
product. Further, according to their current products, they should adopt the ABC system. This
system will impute the indirect costs for each product more accurately, thus helping the
company to prevent declining profits in the future.

2. In order to compute capacity cost rate, the practical capacity and the cost of capacity
supplied were considered.1
The practical capacity, the manufactures output, expresses the number of hours used for each
activity. This number is not the maximum output that machines and workers can produce
(theoretical capacity), but the maximum output minus the time spent associated with repairs,
maintenance, setups, etc.

1
Capacity cost rate = (Cost of capacity supplied/Practical capacity of resources suplied)
In calculating the cost of capacity supplied, the total costs of Manufacturing Overhead for each
activity were considered. These costs can be found in exhibit 1 of the case.
The procedure for the calculation of the cost per unit for each activity is as follows:
For the Production Employees, 45 employees work in each of the two shifts, so 90
employees were considered. Then, this was multiplied by the number of hours worked in a
month which is 120*90=10800 hours. For the direct labor expenses, the full compensation
of employees was multiplied by the number of workers (3,900$*90= 351,000$). Moreover,
to obtain the cost per unit, the total cost of the Direct Labor Expense was divided by the
practical capacity (351,000/10,800=32.5$).
For the Machine Hours, 62 machines were considered for component processing. Because
workers have to be actively engaged to run these machines, the available time to operate
with the machines had to be taken into account. Therefore, the total practical capacity
equals to 62 machines times the number of hours that workers worked per month
(62*2*20*6=14,880). The operating expenses for the machines were $5,400 per month
multiplied by the number of machines (5,400*62=334,800). Finally, the cost per unit of
machine hours is the cost of the Machine Operating expenses divided by the practical
capacity (334,800/14880=22.5$).
For the Receiving and Production Control, 4 people were considered to work for 20 days,
for 6.5 hours a day. In this activity, the workers do not need to spend 30 minutes for
preventive maintenance and minor repair of the machines which allows them to work half
an hour more, as compared to production, assembly and setup workers. So the total number
of hours per month worked by the employees account for 4*20*6.5=520 hours. This
corresponds to the available capacity of employees for receiving and production control
activities. However, it took a total of 75 minutes (1.25 hour) to get one batch of components
done with all the activities required in this department. Taking this into account, we can
calculate the practical capacity in terms of number of production runs for each month as
520/1.25=416. The operating expenses for receiving and production control are 15600$.
Thus, the cost-driver rate is 15600$/416=37.5$.
For the Packaging and Shipment, 14 people worked in each of the two shifts for 6.5 hours
for 20 days a month (14*2*6,5*20= 3640 hours/month). In this situation, each shipment
took 50 minutes plus 8 minutes to bubble wrap and pack the carton. So the number of
shipments for each month is 3640/(58/60)=3,765.5. The total expense for packaging and
 shipping are 109,200. Hence, to obtain the cost per unit, the total cost of the packaging and
shipping was divided by the practical capacity (109,200/3,765.5=29$).
For the Engineering, 8 engineers were considered for designing and developing, they
worked for 20 days in a month for 6 hours per day (8*20*6=960 hours). The total cost
associated with the engineers was 8*9,750=78,000$. Then applying the formula for the cost
per unit, we get 78,000$/960=81,25$ per hour.
Practical Capacity Total Capacity Total Cost Cost/Unit
Production Employees (hours) 10,800 351,000 $32.50
Machines (hours) 14,880 334,800 $22.50
Setup (hours) 3,600 117,000 $32.50
Receiving and Production Control (Number of
416 15,600 $37.50
production runs)
Packaging and Shipment (Number of Shipments) 3,766 109,200 $29.00
Engineers (hours) 960 78,000 $81.25

3. In order to compute the manufacturing overhead costs, according to the time-driven ABC
approach, it is necessary to compute the time required for each activity, and then multiply that
value with the cost-driver rate.

In case of Total Machine hours, it contains the number of machine hours plus the setup hours.2
For valves, the total machine hours are 7,500*0.5+5*20=3,850. As mentioned, the total number
of machine hours was then multiplied by the cost-driver rate: 3850h*22,5$=86,625$.

Similarly, for total setup hours per month, the setup hours per run and the number of runs were
considered, and then multiplied by its cost-driver. For valves, the result obtained was as
follows: 5*20*32,5$=3,250$.

Furthermore, for the production runs, number of shipments and the hours of engineering work,
we picked the values found in Exhibit 4, and then multiplied them by their correspondent cost-
drivers. So in case of valves, the total cost for production runs were 20*37.5$=750$. The total
cost of shipments, is 40*29$=1,160$. And lastly, the total cost of designing and developing
new products, is 60*81.25$=4,875$.

For the Pumps and Flow Controllers, a very similar approach was used as shown in the
spreadsheet, annex 2.

2
Ratio machine hours per unit* Number of units + Number of hours per run * Number of production runs
The values for the total cost, and total cost per unit can also be found in annex 2 of the
spreadsheet. There, it is also possible to find out the total cost/unit for each activity, as obtained
by dividing each of the total costs by the number of units produced for valves, pumps and flow
controllers.

To obtain the new manufacturing overhead costs, each unit cost for the different activities were
summed up. Then the total factory cost3 was calculated. Further, we obtained the new gross
margin percentages.4 The graph below shows the comparison between the previous gross
margins and the new gross margins calculated with the ABC system. More details can be found
in the spreadsheet annex-3.

100%
Differences in the Gross Margins
80%
Actual gross
60% margin (%)

40%

20%

0%
Valves Pumps Flow Controllers

Here, it can be seen that for the valves and pumps, the costs computed with the ABC system
are lower than those computed through the traditional costs methods. This influences the gross
margins, as we see that for the Flow Controllers the new gross margin is just 0.40% now, much
lower than the previous gross margin of 38%.

This confirms the previously stated assertion that the flow controllers are highly customized.
As such, more indirect costs are used as compared to the other two products.

In annex 5, it is possible to see that only the flow controllers use more than 50% of the total
resources in case of these activities: Production runs, Setup, Shipments and Engineering work.

These results further signify the importance of ABC method to Sippican, even though the
method may be slightly time-consuming and expensive. If Sippican uses the traditional cost
system, it could take the decision of decreasing the selling price of Flow Controllers since it
would have the highest gross margin. However, with the ABC overhead assignment method,

3
Total Factory Cost= Direct Labor Cost + Direct Material Cost + Overhead
4
Gross Margin(%)= (Selling Price - Total Factory Cost)/ Selling Price
the new margin is close to zero, and thus decreasing the price of the product shall lead Sippican
to lose money while selling Flow Controllers. Also, they could have chosen to maintain the
price of Pumps, and not participate in the price war with their competitors, because the gross
margin is only 5%, and this strategy can lead to decrease in the market share.

4. The new revised costs, calculated with the ABC approach, aid Sippicans management in
accurately identifying the products that use more resources. This in turn, may guide the
management to create a suitable action plan to improve the companys profitability.

Pumps: This product had inaccurately been adjudged to be decreasing the overall gross margin
i.e. just 5%. However, the actual gross margin is 25% and not 5% that was computed with the
traditional cost system. Thus, it is possible for the management team to decrease the prices of
pumps, allowing the company to keep its major presence in the high volume pump product line
and compete with the players that had triggered a price war.

Valves: Similar to the previous case, the new gross margin is 48%, way above the 35% that
Sippican has predicted earlier. Hence, the management could simply enjoy this considerably
large gross margin in this product since its competitors are not using a price cut strategy. This
has also been mentioned in the fourth paragraph of the first page of the case i.e. Although
Scott felt several competitors could now match Parkers quality in valves, none had tried to
gain market share by cutting price

Flow Controllers: The new gross margin is close to zero, instead of 38% previously calculated
with the traditional cost system. In fact, the product that Sippican had been considering to be
the most profitable is actually the worst with regard to generating profits. This happens
because, Flow Controllers are highly customized, and thus more indirect costs are imputed to
them as compared to the other standard products.

Because of low gross margins in the product, the management team should increase the price
of Flow Controllers. This decision should not affect the demand for Flow Controllers much as
mentioned in the case i.e. Sippican had recently raised flow controller prices by more than
10% with no apparent effect on demand. Furthermore, Sippican can also create a second
product line for Flow Controllers, one that is less customized. This could lead the company to
manufacture a product with less indirect costs, and thus gain market share in a customer
segment that requires limited customisation in Flow Controllers.