Case Study Background: Precision Worldwide, Inc. (PWI) manufactures industrial machines and equipment for sale in numerous countries. Repair and replacement parts account for a substantial part of the company’s business. The replacement part in question, steel rings, occur in the machines manufactured only in PWI’s Frankfurt Germany plant, but can also be used on some competitor’s machines. The steel ring manufactured by PWI has an average normal life of about 2 months. Machines require between 2 and 6 rings to operate.
Individual rings are replaced as they wear out. Over the years, competition had increased and now a competitor company, the French firm Henri Poulenc, has entered the market with a superior plastic ring that replaces the steel ring. The plastic ring is less costly to manufacture and has a longer life. Identification of Parties: Precision Worlwide, Inc. | German Firm| Competitor-French Firm| Henri Poulenc| Hans Thorborg| General Manager| Gerhard Henk| Sales Manager| Bodo Eisenbach| Development Engineer| Patrick Corrigan| Parent Company Spokesman|
Specific Situation for Analysis: The PWI sales manager, Gerhard Henk, is asking when this product will be available for him to sell that his competitor already has on the market, particularly in France where the competitor is the strongest. Bodo Eisenbach, the PWI development Engineer, estimates the plastic rings can be produced in about 4 months at a tool and equipment cost of about $7,500. PWI currently has about $390,000 worth of special steel in current inventory that cannot be sold, even for scrap.
Patrick Corrigan, from the parent company spokesman, expects Thorborg to exhaust all steel supplies. If sales of the steel ring continued until the plastic rings were ready for the market about 15,100 rings would remain in stock upon the plastic rings release date. Decision needed: This case is about a competitor coming out with a plastic replacement part appearing to have a significant cost advantage over an original metal part. The decision that must be made is whether to start producing the plastic parts.
Focuses on three key issues involves, doing incremental analysis of what amount of overhead, materials, and direct labor are relevant in making the decision to produce the new part Information supplied from PWI’s cost accounting department: Title| 100 Plastic Rings| 100 Steel Rings| Material| 17. 65| 321. 90| Direct Labor| 65. 50| 196. 50| Overhead* Departmental Administrative| 131. 0065. 50| 393. 00196. 50| Total| 279. 65| 1107. 90| Note:* Overhead was allocated on the basis of direct labor cost. It was estimated that the variable overhead costs included here were largely fringe benefits related to direct labor and amounted to $0.
80 per direct labor dollar or about 40% of the departmental amounts. Possible Options or Alternatives for PWI: 1) Sell only steel rings until plastics rings are ready for the market. Thereafter, sell only plastic rings and scrap all remaining steel rings and steel inventory (sunk cost). 2) Sell only steel rings until plastics rings are ready for the market. Thereafter, sell plastic rings only in markets where the competitor offers plastic rings. Manufacture and sell steel rings in other markets till all steel is exhausted. Then sell plastic rings only.
3) Sell steel rings until plastics rings are ready for the market. Thereafter, sell plastic rings in markets where the competitor offers plastic rings and sell steel rings in other markets till all currently manufactured steel rings are exhausted. Scrap remaining steel stock. Then sell plastic rings only. 4) Sell steel rings until plastics rings are ready for the market. Thereafter, sell both plastic and steel rings. Sell steel rings at a reduced cost due to less longevity than plastic ring. Manufacture and sell steel rings until all steel stock is exhausted.
Then sell plastic rings only. 5) Sell steel rings only and do not sell plastic rings at all. Possible Concerns for PWI: 1) Cost of scrapping unused manufactured steel rings. 2) Cost of scrapping unused steel stock. 3) Ramifications of alienating customers that learn later that a superior plastic ring in existence was not offered to them by PWI. 4) Not entering the plastic ring market soon enough or at all could lose existing or potential customers. 5) The effect of plastic ring versus steel ring lifespan. Relevant Information:
Table 1: To compare cost of Plastic ring and Steel ring, we need to eliminate the costs that are same for both and also that does not contribute to manufacturing. In this case, the administrative overhead is non manufacturing cost and also we will not be able to trace it steel rings or plastic rings, if both are manufactured. Quoting from Frank, in his book , “when we are choosing between two policies under both of which the same overhead outlay will have to be met, that overhead outlay is not part of the cost specifically traceable to either polity.
” Departmental overhead cost is 80% or $. 8 per Direct Labor cost. Relevant cost from Table A of case study supplied by cost accounting department of PWI, with administrative overhead cost removed and departmental overhead cost reduced. Title| 100 Plastic Rings| 100 Steel Rings| Material| 17. 65| 321. 90| Direct Labor| 65. 50| 196. 50| Overhead* Departmental (80% of Direct Labor) | 52. 4| 157. 2| Total| 135. 55| 675. 60| Using the above table, for incremental analysis purpose, Unit cost of Plastic Ring = $135. 55 / 100 = $1. 36 Unit cost of Steel Ring = $675. 60 / 100 = $6.
76 Table 2: Relevant cost from Table A of case study supplied by cost accounting department of PWI with steel ring material costs included as a sunk cost, administrative overhead cost removed, and departmental overhead cost reduced. For this analysis purpose, if we consider that PWI is going to stop making steel rings, the cost of materials already bought is a ‘sunk cost’ to the extent that it exceeds what the materials are now worth if sold or held for future use. For 100 Steel Rings: Cost of Material (Sunk Cost): (321. 90) Cost of Labor (100% labor charge): 196. 50
Cost of overhead: 157. 2 Total cost – Sunk cost: 675. 6 – 321. 9 = $353. 7 Unit cost of Steel Ring (with Material cost as Sunk): 353. 70 / 100 = $3. 54 Table 3: Relevant cost from Table A of case study supplied by cost accounting department of PWI with steel ring Labor costs at the 70% of regular wages during slack period and, steel ring material costs included as a sunk cost, administrative overhead cost removed, and departmental overhead cost reduced. For 100 Steel Rings: Cost of material (Sunk Cost): (321. 9) Cost of Labor (70% of regular labor charge): $137. 55
Cost of overhead: $157. 2 Total Cost – Sunk Cost = $294. 75 Unit cost of Steel Ring (with Material cost as sunk cost and labor charges reduced to 70%): $294. 75 / 100 = $2. 95 6) Table 4: The effect of Plastic Ring versus Steel Ring Lifespan. Assume a company called ‘A’, needs 6 rings to operate the machine Life Span of Steel Ring: 2 Months; In 16 months, they replace 6 rings every two months. So, total needed Steel Rings: 6 * 8 = 48 Steel Rings. Life Span of Plastic Ring (4 times the wearing property): 8 Months; In 16 months, the same company would need 6 * 2 = 16 Plastic Rings.
This means, when the plastic rings are available in the market, the price of steel rings should be 1/3 of the plastic ring to make sure a company would use either steel ring or plastic ring. Conclusion: Hans should go with my scenario number 4; Sell steel rings until plastics rings are ready for the market. Thereafter, sell both plastic and steel rings. Sell steel rings at a reduced cost due to less longevity than plastic ring. Considering the sunk cost and the reduced departmental and direct labor cost, the cost of steel ring is less ($2. 95 per unit) when compared to its original cost of $6.
76 per unit. Manufacture and sell steel rings until all steel stock is exhausted. Then sell plastic rings only. Hans should instruct his development engineer, Bodo Eisenbach, to begin the process to enable the company to manufacture the plastic rings. He should continue to manufacture and sell steel rings until the plastic rings are available. When the plastic rings become available he should instruct his Sales Manager, Gerhard Henk, to sell the plastic rings only in the jeopardized markets and to push the steel rings, at a reduced cost (table 3), in all other markets.
All customers should be notified of the new plastic rings and given the choice of plastic or steel. During the slack manufacturing period, Hans should instruct the factory to concentrate on manufacturing steel rings at the reduced labor rate to incur a surplus of steel rings and during peak season to concentrate on manufacturing plastic rings. Manufacturing and selling of the steel rings should be continuously monitored. If a point in time arrives, that steel ring sales are faltering, than production of steel rings should stop and all remaining steel scrapped as a sunk cost.
This should also be enough justification for Patrick Corrigan, the Parent Company Spokesman, who suggested that all remaining steel stock be used up. Eventually the company will sell plastic rings only and all remaining steel will be a sunk cost, but I think Hans should try to take advantage of the lower labor cost during the off season and sell as much of the inventory steel as possible. : Frank, W. G. 1990. Back to the future: A retrospective view of J. Maurice Clark’s Studies In The Economics of Overhead Costs. Journal of Management Accounting Research (2): 155-166.