Berk 1

Berkshire Threaded Fasteners Co.

Question 1: Drop 300 as of 1/1/74?
Volume = 501,276 units of 100 items each CM/100 = $1.15 (2.70 - 1.55) CM = ~$576,000, rounded or more precisely $1,355 - $773 = $582 Profit now Lost CM Loss $70 ($576) ($506) $70 ($582) ($512)

An alternative format to show the same result is: Std. profit on 100 Std. loss on 200 Fixed costs from 300 (still incurred)(693) + the variances * (favorable) 138 (103)

146 (512)

*This assumes there is no volume effect in these variances, the bulk of which come from over absorption of fixed costs due to the volume increase in 1974.

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Other Issues For Discussion in Conjunction with Question 1

Define variable cost. Table TC-1 is a useful summary for Berkshire.

Define fixed cost. What does it mean when the accountant states the cost is fixed?
Should labor be considered variable? In many foreign countries and many leading U.S. firms (IBM, Hallmark, HP) this cost is considered fixed. When labor is treated as variable cost, the behavioral implications regarding motivation and commitment can be serious management problems. Is the problem insufficient volume? Can you reasonably expect to get more? [A commodity product in a down market and in an industry in long-term decline.]

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TC-1 Contribution Margin by Product1973

Per Unit
List Price Net Price Variable Costs Per Table 3) Factory Labor Raw Materials Power Repairs Total Contribution Margin Allocated Fixed Expenses Full Cost Profit

#100
$2.45 $2.42 .61 .63 .01 .01 $1.26 $1.16 $1.02 $ .14

#200
$2.58 $2.52 .59 .75 .02 .01 $1.37 $1.15 $1.29 ($ .14)

#300
$2.75 $2.70 .70 .81 .03 .01 $1.55 $1.15 $1.38 ($ .23)

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TC-2 Berkshire1973 Earning StatementContribution Format

Units (100) CM/100 CM $(000)
Fixed Costs Rent Factory Overhead Selling Administration Depreciation Interest Total Fixed Costs Allocated Fixed Cost Full Cost Profit $2,199 $ 295 $1,323 ($ 149) $1,364 ($ 219) #100 2,132K $ 1.16 $2,494 #200 1,030K $ 1.15 $1,174 #300 987K $ 1.15 $1,145 Total

$4,813 530 360 1,839 653 1,359 145 4,886 ($ 73)

Berk 5

Management Inferences Regarding Series 300

1. If only contribution analysis is used, a company will never drop any product since it is rare for a product not to cover its variable costs. 2. What should be done when a once successful product stops covering its full costs, as product 300 has? One possibility: develop a product with a higher margin that will use the same assets and can be priced in excess of its full costs. 3. Would you want all your products to have the same characteristics as the 300 line?

Berk 6

Drop 300 Series?

World View In the long run, all costs are variable In the long run, 300 is a loser on a full cost basis In the long run, were all dead Never drop products with positive CM, in spite of negative profit Long run never starts! Keep 300 Right answer in the short run

Long run starts today! Managerial Implication: Drop 300 Right answer in the long run

When do you decide to take action on a product that is OK on a short-run basis but terrible on a long-run basis? When does the long-run start, if not NOW?

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Question 2
Here is the conventional relevant cost analysis for the pricing choice:
Net Revenue 2.42 Less Variable Costs 1.26 Unit Contribution Margin 1.16 Volume 750,000 (2) Total Contribution $ $870,000 Pricing Decision 2.22 1.26 .96 1,000,000 (1) $960,000

1.This represents holding on to current volume levels. How likely is this when the overall market is weakening and we are matching industry price? 2.This represents holding on to 75% of current volume in a weakening market (for a commodity product) while charging 10% above market price. How plausible is this? Is this a long-run or short-run view?

3. Will the fixed costs be the same across these two production levels?

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Comparative Contribution Margin vs Comparative Profit

The contribution margin approach to Question 2 provides a rationale for cutting the price. This can be interpreted as saying that the lower price is more profitable. Actually, the lower price is not viable, long run, although it results in a lower loss!
Is contribution margin thinking helpful here? Or, is it a trap which camouflages the long run loss position? A CM perspective suggests higher volume can compensate for lower margin per unit:

Price CM

$2.42 1.16

$2.22 .96

(Can I get enough more volume at the $.96CM/unit to compensate in total CM dollars?) A full cost perspective suggests clearly that volume cannot compensate for a losing price:

Profit

$.14

($.06)

No volume level can make a losing price equally profitable with a profitable price!

Berk 9

Management Inferences Regarding the Pricing Decision

1. Berkshire sells a commodity product in an industry where several of its competitors are much larger. Bosworth, the dominant company, has announced a price reduction on product line 100. 2. Berkshire has no alternative but to meet Bosworths price. The choice is to match the new price or exit the business. We do not need any financial analysis to reach this conclusion. 3. However, financial analysis can point out that product line 100, on a full cost basis, is now a big loser. Thus, the low price (which Berkshire is forced to meet) is hardly a viable option for the company in the future. 4. When do we take some substantial action about positioning or cost for this product?

Berk 10

The Managerial View on Fixed Costs

One view: Incorporating fixed costs while making decisions is clearly suspect because:
The resulting per unit amount is only accurate at one particular volume level. It may confuse people by making a fixed cost appear to be a variable cost. It involves arbitrary allocation rules which cannot be justified/verified. It distorts Cost-Volume-Profit (CVP) relationships. Economic theory suggests that fixed costs are irrelevant for short-run decisions.

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The Counterview
Economic theory suggests that fixed costs are relevant in the long run.
Many decisions are more long run than short run (there are very few pure short run decisions) Fixed costs must be covered by the products in aggregate, so why not charge each product for a fair share? Whereas full cost distorts the short run perspective, incremental cost distorts the long run view... Which is a bigger sin? Business history reveals as many sins by taking an incremental view as by taking a full cost view (consider the Braniff Fallacy!).

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The Braniff Fallacy

Full fare from Dallas to New York? Full cost + return on investment = $500 Incremental cost = $.79 [for the extra meal (sic)] If charge $99, to fill up the airplane, contribution per passenger = $98.21 There will be contribution, But no profit!

Berk 13

Are the Fixed Costs Relevant for Pricing Decisions?

In Cost Driven Businesses (The seller is a pure price taker.) Cost is clearly irrelevant for pricing. But, Price < Full Cost says: Exit the business or cut cost. In Imperfect Competition (Far and away the more typical situation. All players offer a somewhat unique blend of Product Features/Availability/Terms/Quality/Service/Image/...) Fixed Expenses represent, ex ante, attempts to create monopoly rents. They thus represent a going-in proxy for anticipated value to the customer. If a firm does not attempt to price for them, the firm is disavowing the ex ante differentiation strategy!

Berk 14

Fixed Overhead Allocations1973

(percent of total)
Product Volumes Net Sales ($) Sales (Units) 100 49.5% 51.4% 200 24.9% 24.8% 27.0% 300 25.6% 23.8% 27.9%

The Overall Allocation % 45.1% Individual Overhead Items Selling 49.5% Depreciation 41.6% Other Factory 38.9% General Administration52.8% Rent 35.3% Interest 35.9%

24.9% 31.5% 30.6% 19.9% 29.5% 27.6%

25.6% <=Based on Sales $ 26.9% 30.6% 27.2% 35.1% 36.2%

NOTE: However they allocated the costs, it isnt a simple rule!

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Question 3: Which is Berkshires most profitable product?

Some Possible Measures of Profitability #100 #200 #300 1. PBTFull Cost Basis $295 (149) (219) 2. PBT/UnitFull Cost Basis .14 (.14) (.23) 3. Contribution: Total $ 2,494 1,174 1,145 As % of sales revenue 48% 45% 43% Per Unit 1.16 1.15 1.15 4. Assume Labor is the Scarce resource. The idea here is CM per unit of scarce resource. Contribution per DL Hour DL$/4.20= DLH/unit #100 .61/4.20 = .145238 #200 .59/4.20 = .140476 #300 .70/4.20 = .166667

CM/DLH per unit $1.16/.145238 $1.15/.140476 $1.15/.166667

$7.99 $8.18 $6.90

5. Contribution per machine hour? 6. Value added: Sales Price - (Raw Material + Power) 7. Other Measures... ?

1.78

1.75

1.86

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Some Observations About The Comparative Product Profitability Analysis

1. Other than selling expense, which is clearly allocated on the basis of sales revenue, the other allocations are somewhat puzzling and seem to favor product 100 (50% of sales but only 45% of overhead) and penalize product 200 and product 300 (25% of sales and ~28% of overhead). 2. Alternative ways of allocating what are apparently common costs (Selling, Depreciation, Rent, Administration) can change the ranking of products and can make any of the three a net loser. Does this mean cost allocation is meaningless, or that we should make sure we do the cost allocation as carefully as possible? 3. No one financial metriccontribution per unit, profit per unit, contribution as % of sales, profit as % of sales, product level ROIis defensible across all decision contexts. 4. Each of the three products excels on at least one metric. 5. None of the products looks like a real winner, in the long run. That is, from a broad managerial context, Berkshire has no most profitable product. All three products are dogs!

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An Approximate Balance Sheet (000)

ASSETS Cash $ 1.0M Accounts Receivables 1.3M Inventory 1.3M Equipment-Cost* $27.2M Accumulated Deprn*(13.6M) 13.6M Total $17.2M ASSUMPTIONS: CASHCase says $1 million kept on hand. One months revenue is equal to about $.9M. ACCOUNTS RECEIVABLE45 days sales revenue would be about average for an industrial firm. This is 12.5% of sales. INVENTORY12.5% of sales is 1.3M which implies 6 inventory turns (7.9 1.3 = 6). *EQUIPMENT COSTthis is 20 times the yearly depreciation expense, per case Exhibit 3. ACCUMULATED DEPRECIATIONassumes that equipment is 1/2 depreciated, on average. Older $13.6 (10.0) 3.6 Newer $13.6 (3.6) 10.0 LIABILITIES & OWNERS EQUITY Accounts Payable $ .4M Long Term Debt Owners Equity (Plug) Total 2.4M 14.4M $17.2M

ACCOUNTS PAYABLEassume 45 days raw material purchases. LONG TERM DEBTcalculated from the interest expense, using a 6% interest rate as shown in Exhibit 3 of the case. EQUITY is a plug, given the other assumptions.

Berk 18

Dupont Analysis
Profit Margin =

Net Income Sales Sales Assets

Asset Turns =

=
ROA =

Net Income Assets

Leverage =

Assets Equity

=
ROE =

Net Income Equity

Berk 19

Dupont Analysis 1974, Annualized

Profit Margin = Asset Turns = = ROA = Leverage = = ROE =
Net Income Sales

= =

140 11,163

= 1.2% = .64

Sales Assets

11,163 17,400

Net Income Assets

=
=

140 17,400

= .8%
= 1.2

Assets Equity

17,400 14,500

=
Net Income Equity 140 14,500

= 1%

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Situation Recap
Inferences
Profit contribution > 40% of sales price for all 3 products Fixed costs as a percent of sales @ 47% Specifically, selling cost as a percent of sales (17%) is very high High direct labor as a percent of sales (25%)

Implications
Not bad for an industrial commodities firm Very high for a commodity producer Berkshire spends too much in the sales channel. Or, cost is high because its hard to move me too items! Might imply a highly skilled workforce. Or, we did not cut back the workforce as markets weakened? Capacity not fully utilized Metal fasteners in New England after the post WWII boom of the 50s and 60s?!? Current situation is terminal A grocery store business with jewelry store cost structure Competition (Bosworth) has lower costs, if we can interpret the $2.25 price on 100 as a signal, vs. A stupid gambit. Me too Moi aussi Mir auch Stuck in the Middle

High depreciation as a percent of sales Not likely to see volume growth in this industry All 3 products are long-term, full-cost losers (@ $2.25 on the 100 series) Berkshire does not achieve differentiation Berkshire does not achieve cost leadership

Berk 21

The Strategic Position?

Berkshire does not achieve product differentiation.
Berkshire does not achieve low cost leadership. Berkshire is stuck in the middle in a seriously declining industry. Given this assessment of the current position of Berkshire, what choices do they have? Slide 22 shows some of their options. We dont plan to spend much time on this list or to push very hard for a firm solution, but we believe it is useful to provide this kind of context at the end of the class. Taking a narrow perspective on questions 1, 2, and 3 using relevant cost analysis just does not capture the richness of the management dilemma in this case. In summary, we think this is an excellent case near the beginning of the course. It provides good reinforcement on basic cost analysis concepts for add/drop, product emphasis, and competitive pricing. But it also shows these concepts in the context of a much richer management setting which can be used to illustrate a broader vision of the role of managerial cost analysis.

Berk 22

Berkshire FastenersBasic Strategic Options

I. Change the Product Mix Note that no mix of 3 losing products can gain real success. II. Cost Reduction (Retrench?) Note that a small player like Berkshire is never likely to win the cost leadership battle.

III. SWOT Analysis might imply trying to become a Contract Manufacturing Shop
We have good machines, workers and sales people but poor products. Can we sell our manufacturing capability to firms who are willing to buy manufacturing? IV. New Products - Evaluate key strengths we could use for new products - Find niches that play to our strengths V. Sell the Company Quick!! To whom? Why? What will they do with it? Does Bosworth need extra capacity? (Unlikely.) Is there really any going concern value (goodwill) for Berkshire?

VI. Hunker Down & Hope

Rationalize do nothing by more study!

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Top 10 Reasons Why Berkshire Isnt A Particularly Well-Managed Firm

10. They are not a market leaderlack of vision? They are just a me too player, stuck in the packIf you arent the lead dog, the view is pretty much the same all the time! 9. They accept the idea that their products are commodities. No attempts at differentiation. Strictly a price-taker (no apparent marketing strategy at all). A dangerously useless variance reporting format (Exhibit 4). No kaizen perspective1974 standards equal 1973 actual costs.

8. 7. 6.

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Top 10 Reasons Why Berkshire Isnt A Particularly Well-Managed Firm

5. 4. 3. They treat the labor force as a variable cost. They use inspectors (treat quality as an inspection issue). They treat repairs as a variable cost (vs. programmable maintenance). How would you like to fly an airline that treats maintenance as a variable cost? They build allowable scrap rates into the standard materials cost and thus condone normal waste. How much waste should be allowable?

2.

1.

The firm is earning seriously inadequate returns on invested capitalunintended gradual liquidation of shareholder value.