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Table of Contents

Walden Company 11.

Woody's Wide World of 12. Furniture

13. Matador Equipment

14. Child's Play (A)

15. Cambridge Business Conferences 16.

MBA Textbook 17.

Destin Brass Products 18.

Dakota Office Products 19.

Child's Play (B) 20.

Baldwin Bicycle 21.

Sheridan Carpets

Chalice Wines

Kiwi Company

Software Associates

Bay Industries

Chapparal Beef

Tashtego

Maverick Lodging

Dragon Development

Shady Hills Golf Course

Birch Paper Co.

WALDEN COMPANY

Walden Company makes and sells wooden furniture. The company is recently approached by a competitor for a possible merger. Mike Lawson, the manager of Walden Company, needs to prepare an income statement for an upcoming meeting with the company's board of directors. At the meeting, the board will discuss the merger proposal and other operating decisions. Mike asked the company's accountants to prepare updated financial reports for the meeting. The company has collected the following information about its activities for 2010. During the year 2010, the company's sales amounted to $600,000. The costs incurred by the company in 2010 were as follows:

Raw materials purchased Direct labor (20,000 hours) Indirect labor Equipment rent Factory utilities Miscellaneous factory supplies Building depreciation Property taxes on building Production salaries Administrative salaries Miscellaneous selling and administrative costs

Inventory balances at the beginning and end of the year were as follows:

Raw materials Work in process Finished goods

January 1 $ 21,000

30,000 45,000

December 31 $ 17,000

35,000 47,000

$ 70,000 180,000

15,000 25,000 10,000 17,000 15,000 5,000

75,000 120,000 29,000

About sixty percent of the factory building was devoted to manufacturing operations, so sixty percent of building depreciation and property taxes is treated as a factory cost. The company was subject to an income tax rate of 30 percent.

Required

1. The merger partner requires that Walden provide the following information for 2010:

1. Cost of raw materials consumed 2. Factory overhead incurred 3. Cost of furniture manufactured 4. Cost of furniture sold 5. Selling and administrative expenses incurred

2. Prepare a summary income statement for Walden Company for 2010.

3. One of the new jobs that Walden completed during the year was for a discount retailer who ordered a batch of dinning tables. Direct materials consumed for this job amounted to $7,000. Three thousand hours of direct labor were spent on the job, at a total cost of $20,000. Per the terms of the contract, the purchaser was to pay Walden the cost of making the tables plus a profit of twenty percent of the cost. Determine the total price for the tables, according to the terms of the contract.

2

WOODY'S WIDE WORLD OF FURNITURE!

Woody's Wide World of Furniture manufactures unfinished furniture. A small production unit in Jamestown specializes in two items: an end table and a footstool. These are just two of many items which Woody's produces, but are the only two produced in the Jamestown facility.

For each item - end tables and footstools - the manufacturing process involves three machines: a table saw, ajig saw, and a sander. Jamestown has one of each of these machines and one operator for each machine; the operators are not cross-trained. After the component pieces are made by processing on each of the machines as needed, the item is put together by Don, the assembler. The Jamestown site thus has four workers and Marilyn, the plant manager.

End tables sell for $90 each, and Woody's can sell up to 100 units per week. Raw material for an end table consists of one piece of I " maple round stock, which costs $20 and one piece of 12"xI6"xl" maple, which also costs $20. Production and assembly are relatively simple: • The maple round stock goes to the table saw, operated by Alice, and is cut into pieces for the

legs; this operation takes IS minutes. After this the legs are sanded by Charlie; time required is 10 minutes.

• The 12"xI6"xl" piece goes to Brad at the jig saw and is shaped; this takes 15 minutes. The shaped piece then goes to Charlie, who takes 5 minutes to sand it.

• Finally, all pieces go Don and are assembled using small metal brackets (cost is $5 per set); assembly takes 10 minutes.

Footstools sell for $100 each; at most, 50 of these may be sold each week. Each footstool requires one piece of the 12"xI6"xl" maple and one piece of2" pine round stock, which costs $20. As with the end tables, production and assembly are relatively simple: • The 12"xI6"xl" piece goes to Brad and is shaped; this takes 15 minutes. • The shaped piece then goes to Charlie, and is sanded in 5 minutes. (This same piece is also

used in the end tables.) • The pine round stock goes to the table saw (Alice) and is cut into pieces for the legs; this

takes I 0 minutes. • After this the legs go to the jig saw (Brad) where notches are cut for the cloth upholstery;

notching takes IS minutes. (Note that the legs are not sanded, because they will be hidden by the upholstery; Woody's sells this product as unfinished furniture, without the upholstery.)

1 Adapted from a problem prepared by Professors Sanford Gunn and Philip Peny

• All pieces then go to Don, where final assembly takes 5 minutes.

Alice, Brad, Charlie and Don each work a guaranteed 40 hours per week; each of the workers receives pay and benefits equal to $15 per hour. It costs a total $6,000 per week to operate the plant, including Marilyn's salary, wages and benefits of the four production workers, heat, lights, rent, etc.

Marilyn currently faces two problems. First, headquarters has just instituted a new planning process and, as part of this process, she must submit a profit target for next week. Second, an engineering student intern from Jamestown Community College just presented her with his report in which he recommends purchasing a different type of jig saw. This would cost $5,000 and would reduce the time for Brad to shape each piece from 15 minutes to 14 minutes, but unfortunately would increase the time for Charlie to sand each piece from 5 minutes to 7 minutes.

Marilyn prepared an initial budget, based on the production and sale of 100 end tables and 50 footstools, the maximum projected demand for these products. Her budget resulted in a projected profit of $1 ,500. This seemed a little high, but she checked her figures and everything seemed OK. She noted that her budgeted production required 133.33 hours ofprqduction labor, well below the 160 hours available. She also wondered whether she should use the extra time to produce some tables or footstools for inventory, as Woody's was about to begin a new advertising campaign for its products in the hope of increasing demand. Marilyn had majored in production management at UB; she wished now that she had elected the course in cost accounting when she was a student.

As Marilyn tried to decide what profit figure she should commit to for next week, she also tried to figure out how to tell her intern that his recommendation unfortunately ignored a critical variable, product cycle time, and that what she needed was a way to reduce the time required to produce end tables and footstools, not increase it.

Questions to consider:

1. Re-create Marilyn's budget 2. Prepare a diagram of the production process 3. IdentifY the constraint in the production process 4. Is there sufficient capacity to achieve Marilyn'S target sales and profits? 5. Prepare a tentative production plan based on the profitability of each product 6. Prepare a revised profit budget based on the production plan in (5) 7. Does the production plan in (5) achieve the best utilization of the company's constraint? If

not, suggest a new production plan 8. Prepare a revised profit budget based on the production plan in (7) 9. Analyze the intern's proposal in light of what you have learned in steps (1) through (8)

CHILD'S PLAY COMPANY CA)

Child's Play makes plastic rattles, which are marketed through 23 exclusive retailers located in upscale shopping malls. The company sells its products at a price of $8.00 per unit. The following is a breakdown of relevant cost items for production and sales volume of 300,000 units:

Direct material Direct labor (each worker makes 20 units in an hour) Packaging Power, supplies, indirect labor, and other variable production costs Supervisory salaries, equipment rental, and other production costs Commissions to sales staff Shipping Advertising and promotion Administrative staff salaries, depreciation on office equipment, etc

* These costs vary in total with production volume ** These costs vary in total with sales volume.

$0.80 per unit * $10 per hour * $0.75 per unit * $1.20 per unit * $1.80 per unit 10% of price ** $0.50 per unit ** $0.60 per unit $0.90 per unit

The costs are reliable estimates for a volume up to 400,000 units. Beyond 400,000 units, the company would have to rent additional machines (with a capacity of 100,000 units each) at an annual cost of$50,000 per machine in 2010. Total fixed manufacturing and selling costs are each expected to increase in 2011 by 10 percent because of inflation. Variable costs per unit and the selling price would stay the same as in 2010.

Please answer the following questions:

1. What is the contribution margin per unit?

2. What is the total contribution for selling 1,000 units and 100,000 units?

3. What is the break even volume in 2011?

4. What is the profit at 1,000 units and 100,000 above breakeven?

5. What is the profit at 2,000 units below the break even?

6. For 2011, what is the sales volume required to give $100,000 profit before tax?

7. For 2011, what is the sales volume required to give $180,000 after tax?

Matador Equipment Company

Matador Equipment Company sells lawn mowers in the western part of the U.S. Matador offers four models: 110, 120,210, and 220, with the primary differences being engine size and cutting width. Total operating expense for Matador is $30,500 per month. This figure includes labor costs at $15 per hour. There are five employees; each works 175 hours per month. Company policy is to employ the workers on a full time basis, independent offiuctuations in workload. Following are monthly data related to each product:

Model 110 Model 120 Model 210 Model 220

Market demand (units) 140 150 100 135 Selling price per unit $125 $170 $150 $200 Raw material costs per unit $ 55 $ 80 $ 65 $ 90 Direct labor hours per unit 1.45 1.50 1.55 1.70 Production process requirements:

Worker A (hours per unit) 0.50 0.50 0 0 Worker B (hours per unit) 0 0 0.60 0.60 Worker C (hours per unit) 0.65 0 0.65 0 Worker D (hours per unit) 0 0.60 0 0.65 Worker E (hours per unit) 0.30 0.40 0.30 0.45

Required: I. IdentifY the sequence in which you would fill demand, based on a conventional costing approach (i.e., rank the products in terms of profitability). Calculate monthly profit using this sequence (there is not enough capacity to produce the full market demand on all products).

2. Use a theory of constraints approach to generate a new production plan, and calculate monthly profit under this plan.

3. Management is considering two options to eliminate the constraint identified in (2) above. Option I is to add an additional part-time worker on the constrained activity; this worker would work 100 hours per month; operating expense would increase by $2,000 (wages at $12 per hour, plus $800 in other costs). Option 2 is a redesign of the production process, reassigning certain duties from one worker to another. This option would result in increasing the total labor time for each product, as follows:

Model 110 Model 120 Model 210 Model 220

Direct labor hours per unit 1.50 1.60 1.60 1.75 Production process requirements:

Worker A (hours per unit) 0.60 0.55 0 0 Worker B (hours per unit) 0 0 0.70 0.70 Worker C (hours per unit) 0.65 0 0.65 0 Worker D (hours per unit) 0 0.65 0 0.65 Worker E (hours per unit) 0.25 0040 0.25 0040

Evaluate each option (be sure to identifY the new constraint in each case).

Cambridge Business Conferences

To Consultants

From Helen Wiggins, Conference Organiser

As the newly appointed conference·organiser for CSC, I would welcome your help in analyzing the proposed "Information Technology in the 21 st Century" conference being planned for August. The initial commitments for this conference were already in place when I was hired.

I am concerned with determining whether the conference appears financially viable. At this point, there are several unresolved issues, as you will see in the attached materials

Please e-mail me with any questions.

Cambridge Business Conferences

Cambridge Business Conferences (CBC) is a West Australian based company skilled in the organisation and running of conferences and seminars.1 The company normally runs several such events p·er year and is currently planning a two-day conference to take place at the Metro Hotel, South Perth, in August. The Conference will be titled "Information Technology in the 21 st Century" and will present twelve speakers of international repwtation, five from Western Australia, three from the Eastern States of Australia and two each from the UK and the US. The booking of the venue has incurred the payment of a non­refundable deposit of $2,000. 2

I estimate the following costs and revenues to be applicable:

Costs

a. A daily delegate rate of $30 per head on each day of the Conference, to cover tea/coffee and use of all hotel facilities

b. Meals charged at a standard rate of$12 for breakfast, $18 for lunch, and $28 for dinner

c. Overnight rate for a single room of $49.50 d: Stationery and Conference papers costing $1 Oper delegate pack e. Conference speakers are to be paid a combination of fee plus expenses, and

will be offered meals and overnight accommodation at CBC's expense. The following fees have been agreed, expressed in the home currencies of the presenters, and must be paid even in the event of the prior cancellation of the Conference: 3 @ $500; 2 @ $600; 2 @ $1,000; 1 @ £800; 1 @ US$800. The rernaining speakers have either offered their services free or are prevented from charging a fee (Le., government departments and foreign embassies). Expenses (estimated at $100 out-of-pocket expenses plus travelling expenses per person) are payable only after they have been incurred

f. For the purposes of cost estimation the following schedule of projected ·rf h bid al ares as een emp oye

Origin Economy Fare ($) Business Class ($) US 2,100 5,000 UK 2,400 5,200

East Australia 600 800

g. An advertising budget of $1 ,500 is available for the period March through June

h. The major marketing thrust will be via mail shot. An initial print run of 5,000 brochures has been agreed for distribution by post (45 cents). Envelopes and

I This case was prepared by Prof. Malcolm Smith of the University of So lith Australia. 2 Unless otherwise noted, all amounts are in Australian dollars.

covering letters can be reckoned to add a further 10 cents per addressee. Printing costs can be calculated at $500 set-up plus 15 cents per brochure. Confirmation letters will be sent by post (45 cents) to those delegates making firm bookings.

I. Administration costs and the costs of word-processing mailing lists is estimated to amount to $7,000.

Revenues

Pilot testing reveals that delegates will be prepared to pay a Conference fee of around $700, the rate to include overnight accommodation between the days of the Conference and inclusive of all meals from lunch on Day 1 through lunch on [lay 2. Any delegates requiring overnight accommodation prior to Day 1 will be billed separately. The venue can accommodate a maximum of 150 delegates in theatre style, or 90 delegates in seminar style, over each of the two days of the conference.

MBA Textbook Company Part One

The MBA Textbook Company produces textbooks. During the current year, four textbooks are produced, which will be designated A, B, C, and D.

Texts A and C serve small-enrollment courses, selling 100 copies annually. Texts B and D serve large-enrollment classes, selling 1,000 copies annually.

Texts A and B are 200-page books, while texts C and D are 600-page books.

This infonnation, along with material costs and labor hours; is summarized below:

Text Quantity Material Cost Labor Hours A 100 $600 50 B 1,000 6,000 500 C 100 1,800 150 D 1,000 18,000 1,500

Labor costs $10 per hour. Total overhead costs are $77,240. Overhead is assigned to product on the basis of labor hours.

Detennine the per-unit cost of each product.

MBA Textbook Company Part Two

The MBA Textbook Company now decides to do a detailed analysis of its overhead. It finds that overhead costs can be grouped into four activities, as follows:

Production-related activities Setups for production runs Number of customer orders processed Maintaining each title in the product line

The amount of each activity is reasonably measured by the following: Production-related activities: machine hours Setups for production runs: flumber of setups Number of customer orders processed: number of orders. Maintaining each title in the product line: /lumber of titles

Utilization of each activity by each of the company's products is as follows:

Text Machine Hours Setups Orders A 50 10 20 B 500 30 60 C 150 10 20 D 1,500 30 60

The overhead cost of $77,240 has been broken down by activity, as follows:

Production overhead Setup overhead Order processing overhead Title maintenance overhead

Total

Determine the per-unit cost of each product.

$35,640 10,000 11,600 20,000

$77.240

Titles 1 1 1 1

Harvard Business School 9-190-089 Rev. April 24, 1997

Destin Brass Products Co.

Every month it becomes clearer to me that our competitors either know something that we do not know, or they are crazy. I realize that pumps are a major product in a big market for all of us, but with the price cutting that is going on, it is likely that no one will be able to sell pumps profitably if they keep forcing us to match their lower prices. I guess we should be grateful that competitors seem to be overlooking the opportunities for profit in flow controllers. Even with the 12!&7'o price increase we made there, our sales representatives report no new competition.

Roland Guidry, president of Destin Brass Products, was discussing product profitability in the latest month with Peggy Alford, his controller, and John Scott, his manufacturing manager. The meeting among the three was taking place in an atmosphere tinged with apprehension because competitors had been reducing prices on pumps, Destin Brass Product's major product line. With no unique design advantage, managers at Destin had seen no alternative except to match the reduced prices while trying to maintain volumes. Moreover, the company's profits in the latest month had slipped again to be lower than those in the prior month.

The purpose of the meeting was to try to understand the competitive trends and to develop new strategies for dealing with them if new strategies were appropriate. The three managers, along with Steve Abbott, sales and marketing manager, who could not attend because he was away, were very concerned because they held significant shares of ownership in Destin Brass Products. Locally, they were a success story; the company had grown to be a significant business in Destin, Florida, better known for its white sand beaches and as "the Luckiest Fishing Village in the World."

The Company

Destin Brass Products Co. was established by Abbott, Guidry, and Scott, who purchased a moribund commercial machine shop in 1984. Steve Abbott had sensed an opportunity in a conversation with the president of a large manufacturer of water purification equipment who was dissatisfied with the quality of brass valves available. John Scott was a local legend because of the high-quality brass boat fittings he had always manufactured for the fishing fleet along the Florida Gulf Coast. Roland Guidry had recently retired from the United States Air Force, where he had a long record of administrative successes. The three then selected Peggy Alford, an accountant with manufacturing experience, to join them.

John Scott was quick to analyze the nature of problems other manufacturers were having with water purification valves. The tolerances needed were small, and to maintain them required

Professor William J. Bruns prepared this case as the basis for class discllssion rather than fa illustrate either effective or ineffective handling of an administrative situation.

Copyright © 1989 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means-electronic, mechanical, photocopying, recording, or otherwise-without the permission of Harvard Business School.

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190-089 Destin Brass Products Co.

great labor skill or expensive machine controls, or both. Within weeks of forming the company, Scott and his shop crew were manufacturing valves that met or exceeded the needed specifications. Abbott negotiated a contract with the purification equipment manufacturer, and revenues soon were earned.

The company had grown quickly because the demand for water purification equipment increased, and Destin Brass Products became the sole supplier of valves to its customer. However, Abbott and Guidry both had greater ambitions. Knowing that the same manufacturing skills used in machining valves could also be used in manufacturing brass pumps and flow controllers, they created an engineering department and designed new products for those markets. Pumps were known to be an even larger market than valves, and flow controllers were 'often used in the same fluid distribution systems as valves and pumps. Moreover, by specializing in brass, the company could exploit Scott's special knowledge about working with the material.

Destin did no foundry work. Instead, components were purchased from brass foundries and then were precisely machined and assembled in the company's new modern manufacturing facility. The same equipment and labor were used for all three product lines, and runs were scheduled to match customer shipping requirements. The foundries had agreed to just-in-time deli"eries, and products were packed and shipped as completed. Guidry described the factory to his friends as "a very modern job shop in specialized products made from brass."

The Products

Valves (24% of company revenues) were created from four brass components. Scott had designed machines that held each component in jigs while it was machined automatically. Each machinist could operate two machines and assemble the valves as machining was taking place. The expense of precise machining made the cost of Destin's valves too high to compete in the nonspecialized valve market, so all monthly production of valves took place in a single production run, which was immediately shipped to its single customer upon completion. Although Scott felt several competitors could match Destin's quality in valves, none had tried to gain market share by cutting price, and gross margins had been maintained at a standard 35%.

Pumps (55% of revenues) were created by a manufacturing process that was practically the same as that for valves. Five components required machining and assembly. The pumps were then shipped to each of seven industrial product distributors on a monthly basis. To supply the distributors, whose orders were fairly stable as long as Destin would meet competitive prices, the company scheduled five production runs each month.

Pump prices to distributors had been under considerable pressure. The pump market was large, and specifications were less precise than those for valves. Recently, it seemed as if each month brought new reports of reduced prices for pumps. Steve Abbott felt Destin had no choice but to match the lower prices or give up its place as a supplier of pumps. As a result, gross margins on pumps sales in the latest month had fallen to 22%, well below the company's planned gross margin of 35%. Guidry and Alford could not see how the competitors could be making profits at current prices unless pumps were being subsidized by other products.

Flow controllers (21 % of revenues) were used to control the rate and direction of flow of liquids. As with pumps, the manufacturing operations required for flow controllers were similar to those for valves. More components were needed for each finished unit, and more labor was required. In recent months, Destin had manufactured 4,000 flow controllers in 10 production runs, and the finished flow controllers had been distributed in 22 shipments to distributors and other customers.

Steve Abbott was trying to understand the market for flow controllers better because it seemed to him that Destin had almost no competition in the flow controller market. He had recently raised flow controller prices by 12V2% with no apparent effect on demand.

2

Destin Brass Products Co. 190-089

The Meeting

After the latest month's results had been summarized and reported, Roland Guidry had called Peggy Alford and John Scott into his office to discuss what changes they could or should make in their course of actions. The meeting had opened with his statement above concerning competition in pumps versus flow controllers. Guidry had a copy of the product profitability analysis (Exhibit 1) on his desk.

John Scott (Manufacturing manager): It really is amazing to me as well that our competitors keep reducing prices on pumps. Even though our manufacturing process is better than theirs, I truly do not believe we are less efficient or cost effective. Furthermore, I can't see what their motives can be. There are many manufacturers of pumps. Even if we or even several competitors were to drop out of the market, there would still be so many competitors that no monopoly or oligopoly pricing could be maintained. Maybe the competitors just don't realize what their costs are. Could that be, Peggy?

Peggy Alford (Controller): That does not seem likely to me! Cost accounting is a well-developed art, and most competent managers and cost accountants have some understanding of how product costs can be u1easured. In manufacturing businesses like ours, material and labor costs are pretty easily related to products produced, whether in the product design stage or after the fact. So, if anything, our competitors must be making some different assumptions about overhead costs or allocating them to products in some other way. Or, as you said Roland, maybe they have stupidly forgotten that in the long run, prices have to be high enough to provide product margins that cover corporate costs and produce rehun to owners.

Roland Guidry (President): Peggy, I know you have explained to me several times already the choices we could make in allocating overhead to products. In fact, last month you almost sold me on what you called a "modem costing approach," which I rejected because of the work and cost of the changeover. I also was worried about the discontinuity it might cause in our historical data. But I feel that I might need another lesson to help me understand what is happening to us. Could you try once more to explain what we do?

Peggy Alford: I would be happy to try again. We have a very traditional cost accounting system that meets all of our needs for preparing financial reports and tax returns. It is built on measurements of direct and indirect costs and on assumptions about our production and sales activity (Exhibit 2). Each unit of product is charged for material cost and labor cost; material cost is based on the prices we pay for components, and labor cost is based on the standard times for run labor times the labor pay rate of $16 per hour. Overhead cost is assigned to products in a two-stage process. First, the overhead costs are assigned to production-in our situation, we have only one producing department so we know all overhead costs are assigned correctly at the first stage. Then, we allocate the total overhead cost assigned to production on the basis of production-run labor cost. Every $1.00 of run labor cost causes $4.39 of overhead to be allocated to the product to which the labor was applied. You can see how this works in our "Standard Unit Costs" sheet, which I brought with me (Exhibit 3). This is a fairly inexpensive way to allocate overhead cost because we have to accumulate direct labor cost to prepare factory payroll, and we just use the same measurement in product costing.

Roland Guidry: All this looks familiar to me. But remind me again what the choices we discussed earlier were.

Peggy Alford: Well, one choice advocated by some would be to forego the overhead cost allocation altogether. Overhead costs could be charged each month as period expenses. Product profitability would then be measured at the contribution margin level, or price less all variable costs, which in our situation are direct material costs. We would still have to make some adjustments at the end of any period we held inventory to satisfy reporting and tax return requirements, but the effort to do that would be fairly trivial. The bigger danger would be that we would forget that all overhead costs have to be covered somehow, and we might allow our prices to slip.

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190-089 Destin Brass Products Co.

John Scott: Yeah, the salesman's mentality in Steve Abbott would make that kind of direct cost accounting dangerous. He would be looking for marginal customers willing to pay marginal prices based on marginal costs. From the outset, we have succeeded in part because we insisted on trying to maintain a 35% gross margin on costs including allocated overhead.

Roland Guidry: John, the competitors are real and so are their prices. If we want to stay in pumps, we probably have to meet them head-on. Peggy, please go on.

Peggy Alford: The last time we discussed this, Roland, I showed you these revised standard unit costs (Exhibit 4). These are based on a more modern view of the proper way to allocate costs. I put these together in an attempt to allocate better overhead based on activities. First, I identified material related overhead, the cost of receiving and handling material, and allocated that to each product line based on the cost of material. The justification for this change is that material handling does not have any relationship to the labor cost of machining. Second, I took set-up labor cost out of the total overhead and allocated it to each product line. This is a small amount, but the cost of set MPS also had no relationship whatever to the total labor cost of a production run. Finally, I substituted machine hours for labor dollars as a basis for allocating the remaining factory overhead. John [Scott] has really done wonders with our machines, but our expenses for machines are probably more than double the cost of labor. Therefore, it seems to me that machine hours better reflect use of an expensive resource and should be used to allocate overhead costs.

The results of this proposal made sense to me and may contain a clue about why competitors are chasing lower prices in the pump market. The revised standard cost for pumps is more than $4.00 below our present standard and would show a gross margin percentage of 27% compared to our current 22%. Maybe our competitors just have more modern cost accounting!

Roland Guidry: And you said this modern approach would not cost much more to maintain once we adopted it?

Peggy Alford: No, it wouldn't. All I really did was to divide the overhead costs into two pools, each of which is allocated on a different measure of activity.

Roland Guidry: And, we could use the same numbers for financial reports and tax returns?

Peggy Alford: Absolutely.

(John Scott had been examining the revised unit costs and suddenly spoke up.)

John Scott: Peggy! This new method makes valves look more costly and flow controllers even more profitable than we know they are.

Peggy Alford: ... or, thought they were! The profit for each product line will change if we change the way we allocate overhead costs to products.

John Scott: I realize that. But it seems to me that product costs should have more to do with the costs caused by producing and selling the product. That's usually true for material and maybe direct labor, but it is not true for most of these overhead costs. For example, we probably spend one-half of our engineering effort on flow controllers, but whether you use direct labor dollars or machine hours to allocate engineering costs to products, flow controllers don't get much of the engineering costs.

I've been thinking about this a lot since last week when I attended an "Excellence in Manufacturing" conference in Tallahassee. One presentation was about "Cost Accounting for the New Manufacturing Environment." I couldn't follow all of the arguments of the speaker, but the key seemed to be that activity, rather than production volume, causes costs. In our operations, it is

4

Destin Brass Products Co. 190-089

receiving and handling material, packing and shipping, and engineering orders that cause us to incur costs, not the length of any production run.

If I understood what this speaker was advocating, it was that whenever possible overhead costs that cannot be traced directly to product lines should be allocated on the basis of transactions-since transactions cause costs to be incurred. A product that required three times as many transactions to be incurred than another product would be allocated three times as much of the overhead cost related to those transactions than the other product would be allocated. Or said another way, a product that causes 3% of the total transactions for receiving components would be allocated 3% of the total cost of receiving components. At a basic level, this seems to make sense to me.

Peggy Alford: Recently I've been reading a lot in my professional magazines about this activity­based costing (ABC) ....

Roland Guidry: But, to cost products that way has got to be more expensive. It's more complex; also, who keeps count of transactions?

Peggy Alford: It can't be too hard. All overhead allocation is somewhat arbitrary. We could experiment with estimates to see how the product costs might be affected. The product costs for material, direct labor, and set-up labor will be the same as for my revised unit costs, and to allocate other overhead costs, we just need to estimate how many transactions occur in total and are caused by each product.

John Scott: I'd like to ask Peggy to put together an analysis for us. The managers at the conference from companies that have used these transaction-based costing systems really seemed excited about what they said they learned.

Roland Guidry: OK. Peggy, you and John get together this afternoon to put together the activity estimates you need. Get back to me as quickly as you can. Maybe we can figure out why the competitors think they should sell pumps regardless of price.

Later

After lunch, Peggy Alford and John Scott met in Peggy's office. They discussed transactions and effort related to each type of overhead cost. The result was the overhead cost activity analysis shown in Exhibit 5.

Required

1. Use the Overhead Cost Activity Analysis in Exhibit 5 and other data on manufachlring costs to estimate product costs for valves, pumps, and flow controllers.

2. Compare the estimated costs you calculate to existing standard unit costs (Exhibit 3) and the revised unit costs (Exhibit 4). What causes the different product costing methods to produce such different results?

3. What are the strategic implications of your analysis? What actions would you recommend to the managers at Destin Brass Products Co?

4. Assume that interest in a new basis for cost accounting at Destin Brass Products remains high. In the following month, quantities produced and sold, activities,

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190-089

6

Destin Brass Products Co.

and costs were all at standard. How much higher or lower would the net income reported under the activity-transaction-based system be than the net income that will be reported under the present, more traditional system? Why?

Destin Brass Products Co. 190-089

Exhibit 1 Product Profitability Analysis

Valves Pumps Flow Controllers

Standard unit costs $37.56 $63.12 $56.50

Target selling price $57.78 $97.10 $86.96

Planned gross margin (%) 35% 35% 35%

Last Month

Actual selling price $57.78 $81.26 $97.07

Actual gross margin 35% 22% 42%

Exhibit 2 Monthly Product and Cost Summary

Product Lines Valves Pumps Flow Controllers

Monthly production 7,500 units 12,500 units 4,000 units

(1 run) (5 runs) (10 runs)

Monthly shipments 7,500 units 12,500 units 4,000 units

(1 shipment) (7 shipments) (22 shipments)

Manufacturing Costs Monthly Total

Material 4 comgonents 5 comgonents 10 comgonents

2@$2~$4 3@$2~ $6 4@ $1 ~ $ 4

2@ 6~ 12 2@ 7~ 14 5@ 2~ 10

1 @ 8~ .Jl Total material 16 $20 $22 $458,000

Labor ($16 per hour including employee benefits)

Set-up labor 8 hours per 8 hours per 12 hours per 168 hours

production run production run production run

Run labor .25 hours per unit .50 hours per unit .40 hours per unit 9,725 hours

Machine usage .50 hours per unit .50 hours per unit .20 hours per unit 10,800 hours

Manufacturing Overhead

Receiving $ 20,000

Materials handling 200,000

Engineering 100,000

Packing and shipping 60,000

Maintenance 30000

Total $410,000

Machine depreciation (units-nf-production method) $25 per hour of use $270,000

7

190-089 Destin Brass Products Co.

Exhibit 3 Standard Unit Costs

Material

Direct labor

Overhead @ 439% oldirect labor $

Standard unit cost

Overhead

Machine depreciation

Set-up labor

Receiving

Materials handling

Engineering

Packing and shipping

Maintenance

Valves

$16.00

4.00

17.56

Total run labor = 9,725 hours x $16 = $155,600

682,688 Overhead rate 439%

155,600

8

Pumps

$20.00

8.00

35.12

$270,000

2,688

20,000

200,000

100,000

60,000

30000

$682,688

Flow Controllers

$22.00

6.40

28.10

Destin Brass Products Co.

Exhibit 4 Revised Unit Costs

Material

Material overhead (48%)

Set-up labor

Direct labor

Other overhead (machine hour basis)

Revised standard cost

Material Related Overhead

Receiving

Materials handling

Total

Overhead Absorption Rate

Valves

$16.00

7.68

.02

4.00

21.30

$220,000

$458,000 48% (materials cost basis)

Other Overhead

Machine depreciation

Engineering

Packing and shipping

Maintenance

Total

Overhead Absorption Rate

$460,000

10,800 hours $42.59 per machine hour

Pumps

$20.00

9.60

.05

8.00

21.30

$58.95

20,000

2QO 000

$220,000

$270,000

100,000

60,000

30,000

$460,000

190-089

Flow Controllers

$22.00

10.56

.48

6.40

8.52

$47.96

9

190-089 Destin Brass Products Co.

Exhibit 5 Monthly Overhead Cost Activity Analysis

Receiving and Materials Handling:

Receive each component once per run

Handle each component once per run

Packing and Shipping:

One packing order per shipment

Engineering:

Estimated engineering work-order percentage (subjective)

Maintenance:

Machine-hour basis

10

Valves

4 transactions (3%)

4 transactions (3%)

1 transaction (3%)

20%

3,750 hours (35%)

Pumps

25 transactions (19%)

25 transactions (19%)

7 transactions (23%)

30%

6,250 hours (58%)

Flow Controllers

100 transactions (78%)

100 transactions (78%)

22 transactions (73%)

50%

800 hours (7%)

CHILD'S PLAY COMPANY (B)

In late 2010, the management of Child's Play is discussing possible changes in the company's marketing plans for 2011. Alternative marketing plans for 2011 are summarized below.

Plan A: Cut price

At the present time we price the product to retailers at $8.00 per rattle. Retailers generally charge the consumers between $9.00 and $9.50. Ifwe cut our price to retailers to $7.50, I expect that the product will do much better. Their increased markup will give them the incentive to display our product more prominently and to promote it more vigorously to customers. We should support this strategy by supplying more promotional materials to retailers, at least another $200 worth to each of our 23 retailers. I expect that we will be able to boost our sales volume by as much as 30 percent.

Plan B: Better packaging

We have a well-designed, safe product which should be very appealing to affluent parents. However, our packaging appears cheap and unattractive. Some of our retailers feel that our product seems out of place in their store. If we improve our packaging, we should be able to boost sales. We have worked with our regular supplier to develop a new type of package that should boost sales by anywhere from 20 to 30 percent. They are willing to supply us the new packaging for $1.25 per unit.

1. Prepare an income statement for 2011, using the contribution format under Plan A and Plan B, respectively. Ignore income taxes.

2. What is the profit equation (as a function of volume) under Plan (A)? Plan (B)?

3. (a) There is one volume of sales at which both marketing plans give identical income (or loss). What is this volume? (b) Which plan would give higher income if the volume is (i) above and (ii) below the volume calculated in part (a). Why?

2

HARVARD BUSINESS SCHOOL

9-102-021 REV: FEBRUARY 18, 2005

ROBERT S. KAPLAN

Dakota Office Products

John Malone, General Manager of Dakota Office Products (DOP) was concerned about the financial results for calendar year 2000. Despite a sales increase from the prior year, the company had just suffered the first loss in its history (see summary income statement in Exhibit 1).

Dakota Office Products was a regional distributor of office supplies to institutions and commercial businesses. It offered a comprehensive product line ranging from simple writing implements (such as pens, pencils, and markers) and fasteners to specialty paper for modern high-speed copiers and printers. DOP had an excellent reputation for customer service and responsiveness.

DOP operated several distribution centers in which personnel unloaded truckload shipments of products from manufacturers, and moved the cartons into designated storage locations until customers requested the items. Each day, after customer orders had been received, DOP personnel drove forklift trucks around the warehouse to accumulate the cartons of items and prepared them for shipment.

Typically, DOP shipped products to its customers using commercial truckers. Recently, DOP had attracted new business by offering a "desk top" option by delivering the packages of supplies directly to individual locations at the customer's site. Dakota operated a small fleet of trucks and assigned warehouse personnel as drivers to make the desktop deliveries. Dakota charged a small price premium (up to an additional 2% markup) for the convenience and savings such direct delivery orders provided to customers. The company believed that the added price for this service could improve margins in its highly competitive office supplies distribution business.

DOP ordered supplies from many different manufacturers. It priced products to its end-use customers by first marking up the purchased product cost by about 15% to cover the cost of warehousing, distribution, and freight. Then it added another markup to cover the approximate cost for general and selling expenses, plus an allowance for profit. The markups were determined at the start of each year, based on actual expenses in prior years and general industry and competitive trends. Actual prices to customers were adjusted based on long-term relationships and competitive situations, but were generally independent of the specific level of service provided to that customer, except for desk top deliveries.

Dakota had introduced electronic data interchange (EDI) in 1999, and a new internet site in 2000, which allowed customer orders to arrive automatically so that clerks would not have to enter customer and order data manuaUy. Several customers had switched to this electronic service because

Professor Robert S. K.lplan prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

Copyright iEl2001 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, ("all 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means---electronic, mechanical, photocopying, recording, or otherwise-without the pennission of Harvard BusineSS School.

102-021 Dakota Office Products

of the convenience to them. Yet Dakota's costs continued to rise. Malone was concerned that even after introducing innovations such as desktop delivery and electronic order entry, the company could not earn a profit. He wondered about what actions he should take to regain profitability.

Distribution Center: Activity Analysis

Malone turned to his controller, Melissa Dunhill and director of operations, Tim Cunningham for help. Tim suggested:

If we can figure out, without going overboard of course, what exactly goes on in the distribution centers, maybe we can get a clearer picture about what it costs to serve our various customers.

Melissa and Tim went into the field to get more specific information. They visited one of Dakota's distribution facilities. Site manager Wilbur Smith confirmed, "All we do is store the cartons, process the orders, and ship them to customers." With Wilbur's help, Melissa and Tim identified four primary activities done at the distribution center-process cartons in and out of the facility, the new desk top delivery service, order handling, and data entry.

Wilbur described some details of these activities.

The amount of warehouse space we need and the people to move cartons in and out of storage and get them ready for shipment just depends on the number of cartons. All items have about the same inventory turnover so space and handling costs are proportional to the number of cartons that go through the facility.

We use commercial freight for normal shipments, and the cost is based more on volume than on anything else. Each carton we ship costs about the same, regardless of the weight or distance. Of course, any carton that we deliver ourselves, through our new desktop delivery service, avoids the commercial shipping charges.

The team confirmed the information with the warehouse supervisor who noted.

This desktop delivery is a real pain for my people. Sure, we offer the service, and it's attracted increased business. But I have had to add people since existing personnel already had more than enough to do.

Melissa and Tim next checked on the experu;es of entering and validating customer order data. The order entry expenses included the data processing system and the data entry operators. They spoke with Hazel Nutley, a data entry operator at Dakota for 17 years.

2

All I do is key in the orders, line by line by line. I start by entering the customer ID and validating our customer information. Beyond that, the only thing that really matters is how many lines I have to enter. Each line item on the order has to be entered separately. Of course, any order that comes in through our new ED! system or internet page sets up automatically without any intervention from me. I just do a quick check to make sure the customer hasn't made an obvious error, and that everything looks correct. This validity check takes about the same time for all electronic orders; it doesn't depend on the number of items ordered.

Melissa and Tim collected information from company data bases and learned the following:

Dakota Office Products 102-021

• The distribution centers processed 80,000 cartons in year 2000. Of these, 75,000 cartons were shipped by commercial freight. The remaining 5,000 cartons were shipped under the desktop delivery option. DOP made 2,000 desktop deliveries during the year.

• People felt this total amount of handling, processing and shipping was about the capacity that could be handled with existing resources.

• The data entry operators processed 16,000 manual orders, and validated 8,000 ED! orders. The 16,000 manual orders had an average of nearly 10 items per order, or 150,000 order lines in total. As with the carton handling, shipping, and delivery personnel, supervisors felt that the data entry operators were operating at capacity rates with the existing business.

They then formed two small project teams, one made up of distribution center personnel and the other of data entry operators, to estimate the amount of time people spent on the various activities they had identified. The teams conducted interviews, asked some people to keep track of their time for several days, and observed other people as they went about their daily jobs.

The distribution center team reported that 90% of the workers processed cartons in and out of the facility. The remaining 10% of workers were assigned to the desktop delivery service. All of the other warehouse expenses (rent, building and equipment depreciation, utilities, insurance, and property taxes) were associated with the receipt, storage, and handling of cartons. The delivery trucks were used only for desktop delivery orders. These estimates were reviewed by supervisors and felt to be representative of operations not just in the current year, but in the past year (2000) as w<?ll.

The data entry team, from monitoring computer records, learned that operators worked 10,000 hours during year 2000. Further analysis of the records revealed the following distribution of time for each of the activities performed by data entry operators.

Activity

Set up a manual customer order Enter individual order lines in an order Validate an EDIIinternet order Total

Understanding Customer Profitability

Data Entry Operators Time

2,000 hours 7,500 hours

500 hours 10,000 hours

Melissa looked through the customer accounts and found two typical accounts of similar size and activity volumes. Customers A and B had each generated sales in year 2000 slightly above $100,000. The costs of the products ordered were also identical at $85,000. The overall markups (21.2% for Customer A, and 22.4% for B) were in the range of markups targeted by Dakota Office Products. The markup for Customer B was slightly higher because of the premium charges for desktop delivery. Both customers had ordered 200 cartons during the year. The existing customer profitability system (see Exhibit 2) indicated that both customers generated a contribution margin sufficient to cover normal general and selling expenses and return a profit for the company.

Melissa noticed, however, that the two accounts differed on the service demands made on Dakota. Customer A placed a few large orders, and had started to use ED! to place its orders (half its orders, in year 2000, arrived electronically). Customer B, in contrast, placed many more orders, so its average size of order was much smaller than for Customer A. Also, all of Customer B's orders were either

3

102-021 Dakota Office Products

paper or phone orders, requiring manual data entry; and 25% of B's orders requested the desktop delivery option.

Melissa, concerned about increases in Dakota's borrowings from the bank, also noticed that Customer A generally paid its bills within 30 days, while Customer B often took 90 or more days to pay its bills. A quick study revealed that the average accounts receivable balance during the year for A was $9,000, while it was $30,000 for B. With Dakota paying interest of 10% per year on its working capital line of credit, Melissa thought this difference might be significant.

Exhibit 3 shows Melissa's summary of the actual ordering, delivery and payment statistics for the two customers. She believed she was now ready to assess the actual profitability of customers, and make recommendations about how to reverse Dakota's recent profit slide.

Exhibit 1 Dakota Office Products: Income Statement CY2000

Sales 42,500,000 121.4%

Cost of Items Purchased 35,000,000 100.0%

Gross margin 7,500,000 21.4%

Warehouse Personnel Expense 2,400,000 6.9%

Warehouse Expenses (excluding personnel) 2,000,000 5.7%

Freight 450,000 1.3%

Delivery Truck Expenses 200,000 0.6%

Order entry expenses 800,000 2.3%

General and selling expenses 2,000,000 5.7%

Interest expense 120,000 0.3%

Net Income Before Taxes (470,000) -1.3%

4

Dakota Office Products 102-021

Exhibit 2 Customer Profitability Report (Current Method)

Customer A CustomerB Sales 103,000 121.2% 104,000 122.4%

Cost of Items Purchased 85,000 100.0% 85,000 100.0%

Gross margin 18,000 21.2% 19,000 22.4%

Warehousing, Distribution and 12,750 15.0% 12,750 15.0% Order Entry

Contribution to general and 5,250 6.2% 6,250 7.4% selling expenses, and profit

Exhibit 3 Services Provided in Year 2000 to Customers A and B

Customer A CustomerB Number of cartons ordered 200 200

Number of cartons shipped 200 150 commercial freight

Number of desktop deliveries 25

Number of orders, manual 6 100

Number of line items, manual 60 180

Number of ED! orders 6

Average accounts receivable $9,000 $30,000

5

Baldwin Bicycle Company

Suzanne Leister, marketing vice president of Baldwin Bicycle Company, was mulling over the discussion she had had the previous day withKari Knott, a buyer from Hi-Valu Stores, Inc. Hi-Valu operated a chain of discount department stores in the Northwest. Hi­Valu's sales volume had grown to the extent that it was beginning to add "house-brand" (also called "private-label") merchandise to the product lines of several of its departments. Mr. Knott, Hi-Valu's buyer for sporting goods, had approached Ms. Leister about the possibility of Baldwin's producing bicycles for I-li-Valtl. The bicycles would bear the name "Challenger," which Hi-Valu planned to use for all of its house-brand sporting goods.

Baldwin had been making bicycles for almost 40 years. Currently, the company's line included 30 models, ranging from a small beginner's model with training wheels to a deluxe 12-speed adult's model. Sales were currently at an annual rate of about $10 million. The company's 1997 financial statements appear in Exhibit 1.' Most of Baldwin's sales were through independently owned retailers (toy stores, hardware stores; sporting goods stores) and bicycle shops. Baldwin had never before distributed its products through department store chains of any type. Ms. Leister felt that Baldwin bicycles had the image of being above average in quality and price, but not a "top-of-the-line" product.

Hi-Valu's proposal to Baldwin had features that made it guite different from Baldwin's normal way of doing business. First, it was very impOliant to Hi-Valu to have ready access to a large inventory of bicycles, because Hi-Valu had had great difficulty in predicting bicycle sales, both by store and by month. Hi-Valu wanted to carry these inventories in its regional warehouses, but did not want title on a bicycle to pass from Baldwin to Hi-Valu until the bicycle was shipped from one of its regional warehouses to a specific Hi-Valu store. At that point, Hi-Valu would regard the bicycle as having been purchased from

, Baldwin, and would pay for it within 30 days. However, l-li-Valu would agree to take title to any bicycle that had been in one of its warehouses for four months, again paying for it within 30 days. Mr. Knott estimated that on average, a bike would remain in a Hi-Valu regional warehouse for two months.

Second, Hi-Valu wanted to sell its Challenger bicycles at lower prices than the name­brand bicycles it carried, and yet still earn approximately the same dollar gross margin on each bicycle sold - the rationale being that Challenger bike sales would take away from the

sales of the name-brand bikes. Thus, Hi-Valu wanted to purchase bikes from Baldwin at lower prices than the wholesale prices of comparable bikes sold through Baldwin's usual channels.

Finally, Hi- Valu wanted the Challenger bike to be somewhat different in appearance from Baldwin's other bikes. While the frame and mechanical components could be the same as used on current Baldwin models, the fenders, seats, and handlebars would need to be somewhat different, and the tires would have to have the name Challenger molded into their sidewalls. Also, the bicycles would have to be packed in boxes printed with the Hi-VaiLl and Challenger names. These requirements were expected by Ms. Leister to increase Baldwin's purchasing, inventorying, and production costs over and above the added costs that would be incurred for a comparable increase in volume for Baldwin's regular products.

On the positive side, Ms. Leister was acutely aware that the bicycle boom had flattened out, and this plus a poor economy had caused Baldwin's sales volume to fallthc past two years. The American bicycle industry had become very volatile in recent years. From 1982 through 1985, industry sales had averaged about 7 million units annually. By 1988 the total was up to a record IS million units. But by 1990, volume was back downto 7.5 million units. By 1997, volume was up to 10 million units, but still well below tl1e peak years.

As a result, Baldwin currently was operating its plant at about 75 percent of one-shift capacity. Thus, the added volume from I-li-Valu's purchases could possibly be very attractive. If agreement could be reached on prices, Hi-Valu would sign a contract guaranteeing to Baldwin that Hie Valu would buy its house-brand bicycles only from Baldwin for a three-year period. The contract would then be automatically extended on a year-to-year basis, unless one party gave the other at least three-months' notice that it did not wish to extend the contract.

Suzanne Leister realized she needed some preliminmy financial analysis of this proposal before having any further discussions with Karl Knott. She has provided the information she has gathered; this information is shown in Exhibit 2.

Cash

EXHIBIT 1 Financial Statements

BALDWIN BICYCLE COMPANY Balance Sheet

As of Decem ber 3 I, 1997

Accounts Receivable Inventories

$ 342,000 1,359,000 2,756,000 3.635,000 Plant and Equipment, net

$8,Q2Z000

Liabilities and Stockholders' Equity $ 512,000

340,000 Accounts Payable Accrued Expenses Short-term Bank Loans Long-term Note Payable

Total Liabilities Stockholders' Equity

2,626,000 1,512,000

$4,990,000 3.102.000

$8,092000

Income Statement For the Year Ended December 3 I, 1997

Sales revenues $10,872,000 Cost of sales 8,045.000 Gross margin $ 2,827,000 Selling and administrative expenses 2.354.000 Income before taxes $ 473,000 Income tax expense 218,'000 Net income $ 255 000

EXHlBJT2

Data Pertinent to Hi-Valu Proposal (Notes taken by Suzanne Leistel)

I. Estimatedjirst-year costs of producing Challenger bicycles (average unit costs, assuming a constant mix of models):

Materials (includes items specific to Hi-Valu models, not used in our standard models)

Labor Overhead at 125% of labor (our accountant says that

about 40 percent of total production overhead cost variable; the 125% rate is based on a volume of 100,000 bicycles per year)

$39.80 19.60

24.50 $83.90

2. Unit price and annual volume: Hi-Valu estimates it will need 25,000 bikes a year and proposes to pay us (based on the assumed mix of models) an average of $92.29 per bike for the first year. Contract to contain an inflation escalation clause such that price will increase in proportion to inflation-caused increases in costs shown in item 1 above; thus, the $92.29 and $83.90 figures are, in effect, "constant-dollar" amounts. Knott intimated that {here was very little, if any, negotiating leeway in the $92.29 proposed initial price.

3. Asset-relatcd costs (annual variable costs, as percent of dollar' value of assets): Pretax cost of funds (to finance receivables or inventories) 18.0% Recordkeeping casts (for receivables or inventories) 1.0 Inventory insurance 0.3 State property tax on inventory 0.7 Inventory-handling labor and equipment 3.0 Pilferage, obsolescence, breakage, etc. 0.5

4. Asslimptioll.l'jiJr Challenger-relaled added inventories (average over the year): Materials: two month's supply. Work in process: 1,000 bikes, half completed (but all materials for them issued) Finished goods: 500 bikes (awaiting next carload lot shipment to a Hi-Valu warehouse).

5. Impact on our regular sales: Some customers comparison shop for bikes, and many of them are likely to recognize a Challenger bike as a good value when compared with a siinilar bike (either ours or a competitor's) at a higher price in a nonchain toy or bicycle store. In 1997, we sold 98,791 bikes. My best guess is that our sales over the next three years will be about 100,000 bikes a year if we forego the Hi-Valu deal. If we accept it, I think we'll lose about 3,000 units of ollr regular sales volume a year, since Ollr retail distribution is quite strong in Hi-Valli's market regions. These estimates' do not include the possibility that a few of our current dealers might drop our line if they find out we're making bikes for Hi-Valli.

Sheridan Carpet Company

Sheridan Carpet Company produces high-grade carpeting materials for use in automobiles and recreation vans. Sheridan's products are sold to finishers, who cut and bind the material so as to fit perfectly in the passenger compartment or cargo area (e.g., automobile trunk) of a specific model automobile or van. Some of these finishers are captive operations of major automobile assembly divisions, particularly those that assemble the top-of-the-line cars that include high-grade carpeting; other finishers concentrate on the replacement and·van customizing markets.

Late in 1997, the marketing manager and chief accountant of Sheridan met to decide on the list price for carpet number 104. It was industry practice to announce prices just prior to the January-June and July-December seasons. Over the years, companies in the industry had adhered to their announced prices throughout a six-month season unless significant unexpected changes in costs occurred." Sales of carpet 104 are not affected by seasonal factors during the two six-month seasons.

Sheridan is the largest company in its segment of the automobile carpet industry; its 1996 sales were over $40 million. Sheridan's sales staff is on a salary basis, and each salesperson sells the entire product line. Most of Sheridan's competitors are smaller than Sheridan; accordingly, they usually await Sheridan's price announcement before setting their own seliing prices.

Carpet 104 has an especially dense nap; as a result, making it requires a special machine, and it is produced in a department whose equipment cannot be used to produce Sheridan's other carpets. Effective January I, 1997, Sheridan had raised its price on this carpet from $3.90 to $5.20 per square yard. This was done in order to bring 104's margin up to that of the other carpets in the line. Although Sheridan was financially sound, it expected a large cash need in the next few years for equipment replacement and plant expansion. The 1997 price increase was one of several decisions made in order to provide funds for these plans.

Sheridan's competitors, however, held their 1997 prices at $3.90 on carpets competitive with 104. As shown in Exhibit I, which includes estimates of industry volume on these carpets, Sheridan's price increase had apparently resulted in a loss or market share. The marketing manager, Mel Walters, estimated that the industry would sell about 630,000 square yards of these carpets in the first half of 1998. Walters was sure Sheridan could sell 150,000 square yards if it dropped the price"of 104 back to $3.90. But if Sheridan held its price at $5.20, Walters feared a further erosion in Sheridan's share. However, because some customers felt that 104 was superior to competitive products, Walters felt that Sheridan could sell at least 65,000 square yards at the $5.20 price.

During their discussion, Walters and the chief accountant, Terri Rosen, identified two other aspects of the pricing decision. Rosen wondered whether competitors would announce a further price decrease if Sheridan dropped back to $3.90. Walters felt it was unlikely that competitors would price below $3.90, because none of them was more efficient than Sheridan, and there were rumors that several of them were in poor financial condition. Rosen's other concern was whether a decision relating to carpet 104 would have any impact on the sales of Sheridan's other carpets. Walters was convinced that ::,iw .. c; 104 was a specialized item, there was no interdependence between its sales and

those of other carpets in the line. Exhibit 2 contains cost estimates that Rosen has prepared for various volumes of

carpet 104. These estimates represented Rosen's best guesses as to costs during the first" six months of 1998, based on past cost experience and anticipated inflation.

Sheridan Carpets (Exhibit 1) Carpet 104: 1995-97 Production Volume (square yards) and Price per square yard

Selling Season

Jan-June 1995 July-Dec 1995 Jan-June 1996 July-Pee 1996 Jan-June 1997 July-Dec 1997

Industry Total 549,000 517,500 387,000 427,500 450,000 562,500

Sheridan Carpets (Exhibit 2) . Estimated Cost of Carpet

104, at Various Production Volumes

Sheridan Com petito Sherida rs n

192,000 $5.20 $5.20 181,000 5.20 5.20 135,500 3.90 3.90 149,500 3.90 3.90 135,000 3.90 5.20 112,500 3.90 5.20

First six months of 1998 Volume in square yards

Raw materials Materials spoilage Direct labor Department overhead:

Direct (see Note 1) Indirect (see Note 2)

General overhead (see Note 3)

TOTAL FACTORY COST Selling & administrative (see Note 4) TOTAL COST

Note 1: materials handlers, supplies, repairs, power, fringe benefits Note 2: supervision, equipment depreciation, heat and light Note 3: 30 'percent of direct labor Note 4: 65 percent of factory cost

65,000 87,000 $0.520 $0.520

0.052 0.051 1.026 0.989

0.142 0.136 1.200 0.891 0.308 0.297

$3.248 $2.884 2.111 1.875

$5.359 $4.759

110,000 150,000 185,000 220,000 $0.520 $0.520 $0.520 $0.520

0.049 0.049 0.051 0.052 0.979 0.962 0.975 0.997

0.131 0.130 0.130 0.130 0.709 0.520 0.422 0.355 0.294 0.289 0.293 0.299

$2.682 $2.470 $2.391 $2.353 1.743 1.606 1.554 1.529

$4.425 $4.076 $3.945 $3.882

Chalice Wines

This case L, set in 1993 in California's Sonoma Valley, home of many wine­making millionaires. Here is where they spend their millions, not where Ihey make them.

The Chalice Wine Group's brochures describe its Cimarron winery in the following tenns:

Cimmaron, A Place in Time

"A pair of red-tailed hawks hover in the thermal plume rising from the cliftS below the Feather Vineyard. In winter, you hear the muted roar of three creeks cascading down the canyons from the ridges above. Fog nestles like ocean foam over the bay and valleys. The rocky outcrops and dense chaparral of rnadrone, oak, laurel and aromatic wild sage are the natural horne" of coyotes, rattlesnakes and mountain lions. The vineyards and winery ofCimmaron are literally carved into the volcanic stone of the mountain-we are here for the long term. A great wine is not a commodity. It must artistically communicate its context, its place and time. We are dedicated to expressing tile most beautiful and unique aspects of a place we love. We hope that you will share in our love of this place called Cimmaron as we apply our skills each vintage to create for you a memorable sensory snapshot in a bottle of wine."

The company is somewhat less effusive in describing its financial results in the 1993 Annual Report:

"Notwithstanding our strong fourth quarter: we had a net loss of $700,000 (after tax) for the year, but that is almost $50,000 less than we lost in 1992."

In fact, things have been pretty much downhill, financially, for Chalice since 1990 as the folIowing trend indicates:

Assets Sales Net Earnings

1990 $49 million $14.2 million $650,000

1991 $68 million $15.0 million $58,000

1992 $70 million $17.3 million $(741,000)

1993 $74 million $18.3 million $(700,000)

76

THE PROJECT

Bill Evanson, President and CEO of Chalice was sharing a bottle of his wine with former colleague Sam Davis. Sam was describing how his just completed first year in the MBA program of a small eastern college had changed his perspective on the wine industry.

"Personally, if a business has no hope of profit then I'm just not interested. But it's not at all clear to me that small wineries are a hopeless cause. I'd hesitate to make that call without understanding what's happening along the entire value chain. Of the retail price somebody pays for a bottle of your wine, where does the money go? How much is profit versus cost for each of the· players involved in making the product and delivering it to the consumer? Is there room for a winery to maneuver upstream or downstream in the value chain? And what causes the costs of each stage for each player? If you don't understand the whole picture, then you may misassess the options when you develop strategies to cope with changing business conditions, or even decide to abandon the effort. The value chain concept is a big deal at B-school these days, and I'm sold On it."

Evanson looked intrigued. "That's interesting Sam. I've been thinking along these same lines lately. What does it cost us to make wines the w<ly we do? Many of our specific costs seem to get Jost within our accounting system. I suspect we understate some and overstate others. Who is making money in this industry, and how do they do it'! This would be great stuff to know. But this is a complex industry-practically every winery has a unique approach, nnd every wine is different. And Chalice is a particularly complicated company. Would a value chain analysis be meaningful, or even possible for this company in this industry?"

Sam Davis grinned and raised his glass. "Why don't we find out, Bill? We can certainly set up the value chain for a particular wine, and hopefully the process will reveal some generalizable insights. I've got the time if you've got the interest. We're drinking one of your wines now, aren't we? Why don't we track this one?"

Bill Evanson watched the slln reflect through the delicate flaxen color of the 1991 Cimarron Meritage White in his glass. "OK, hotshot, let's do it' Come to my office next week and I'll show you the numbers we've gaL"

Chalice Wines

THE CHALICE WINE GROUP (CWG)

Evanson had oat exaggerated \vheo he described Chalice as complicated. The Group owns two vineyards (Chalice and Cimarron) and one'half of a third (Delta). It owns three wineries (Chalice, Cimarron and Alicia) and one-half of a fourth (Opera Valley) which it operates for a management fee on behalf of the joint venture owners. It has a cross-investment with a prominent French wine company for distribution in the US of its French and Chilean wines. CWG also owns a one-half interest in a vineyard in eastern Washington State with plans to build a winery at this site.

Of the four wineries, the flagship is Chalice, founded in 1969. The Opera Valley Joint Venture was established in 1980. Cimarron and Alicia were acquired in 1982 and 1986, respectively. Chalice went public in May of 1984. Until June, 1993 with the initial public offering for Robert Mondavi Winery, Chalice was the only publicly-held company in the United States whose principal business is the production and sale of premium wines. Among the serious patrons of the California wine industry, C\VG enjoys a prestigious reputation for prodUCing consistently elegant wines:

Each of its four California wineries is located in a different legally designated viticultural area. Each one is a separate profit center with its own president, typically the winemaker. The Company's wines are sold in specialty wine shops and grocery stores, and selected restaurants, hotels and private clubs across the country and in certain overseas markets. Virtually every distribution channel in the industry is used by C\VG in one market or another. It's wines are distributed via direct mail in those states where it is legal and, in limited quantities, "over-the-counter" at the wineries. Out of state, the company sells through the traditional 3-tier system (maker, distributor, retailer). In Northern California, a wine distributor is used as a broker. In Southern California, CWG owns and operates its own distribution network.

Because of aging, sales in anyone year do not match that year's production. Exhibit I contains selected industry sales and concentration data for 1991 and 1992. Total production and sales for the company for 1990, 1991 and 1992 are shown in Exhibit 2. Exhibit 3 shows the consolidated financial statements for the company for 1990, 1991, and 1992.

Chalice Wines 77

EXHIBIT 1: California Winery Shipments (000 Cases) *

1992 1991 Cases % total Cases % total

All California Wineries 160,536 100% 157,734 100% E & J Gallo 64,219 40% 66,070 42% Heublein Wines 17,139 11% 15,712 10% (Almaden, Inglenook) The Wine Group 12,777 8% 9,981 6% (Franzia, Summit, MD) Vintners Inte.mational 8,328 5% 8,549 5% (Taylor, Paul Masson) Toe 4 Bulk Wineries 102,463 64% 100,312 63% Sebastiani 4,762 3% 4,749 3% Sutter Home 4,760 3% 4,163 3% Robert Mandavi 3,950 2% 3,261 2% Wine World 3,863 2% 3,285 2% (Beringer, Napa Ridge) Glen Ellen 3,778 2% 3,270 2% Toe 5 Premium Wineries 21,113 12% 18,728 12% 18 Wineries wi Sales of I 00K-250K Cases 2,570 1.60% 2,406 1.53% Chalice Wine Group 175 0.11% 138 0.09%

* estimates from Gomberg, Fredrikson & Associates

EXHIBIT 2: \-Vine Production in Case Equivalents

1992 1991 1990 By Variety Cases % total Cases % total Cases % total

Chardonnay 141,200 68% 131,600 71% 117,900 71% Sauvignon Blanc 4,000 2% 4,100 2% 10,100 6% Pinot Blanc 6,700 3% ·2,800 1% 3,100 2% Other White 5,800 3% 5,600 3% 5,700 4%

Total White 157,700 76% 144,100 77% 136,800 83%

PinotNoir 26,100 13% 23,100 13% 20,200 12% Cabernet Sauvignon 16,900 8% 17,600 9% 6,600 4% Other Red 5,500 3% 1,600 1% 1,600 1%

Total Red 48,500 24% 42,300 23% 28,400 17% Total 206,200 100% 186,400 100% 165,200 100%

"Vine Sales in Cases By Channel Independent Distributors

US 61,100 35% 45,300 33% 42,000 31% International 9,100 5% 5,600 4% 8,700 7%

70,200 40% 50,900 37% 50,700 38% Company Direct

California Retail 90,200 51% 76,000 55% 71,800 53% Mailing List 15,300 9% 11,600 8% 12,000 9%

105,500 60% 87,600 63% 83,800 62% Total Sales 175,700 100% 138,500 100% 134,500 100%

78

EXHIBIT 3: Consolidated Balance Sheets, The Chalice \-Vine Group, Ltd.

(Thousands)

ASSETS Cash Accounts Receivable Inventories Other Current Investment in French Wine Company Property, Plant & Equipment, (net) Goodwill (net) Other

Total

UABIUTIES srr Notes & Current Maturities Accounts Payable & Accruals Long-tenn Debt Other

SHAREHOLDERS' EQUITY Common Stock Retained Earnings

Wine Sales Cost of Sales

Total

Selling, Genera! &. Administrative Expenses Interest Expense Other Expense (net) Income Tax

Net Earnings Net Earnings Per Common Share Stock Price, High

Low

The Chalice Group Consolidated Income Statements

December 31, 1992 1991

$ 74 3,464

26,091 1,007

12,524 22,454 3,297 1503

$lQ 414

$15,512 3,522

30,414 3935

53,383

16,633 398

17,031

~

1992 $17,319

11,011 4,610 2,757

7 (323)

La.ill (0.19)

9.75 7.00

$ 78 2,650

24,298 1,154

12,524 22,290

3,394 1.541

ill.Q28

£12,593 2,236

31,945 4.073

50,847

15,942 .!J3.2

17.081 ill92l!

1991 $14,951

8,096 4,119 2,334

239

1M LiI!

0.02 11.00 8.50

Chalice Wines

1990

$ 185 2,516

19,601 89

3,176 19,582 3,492

509

~

$7,906 2,352

19,658 3.643

33,559

15,215 1.376

16.591 :542JiQ

1990 $14,182

7,296 3,760 1,679

293 505

$ 650 0.18

11.00 7.75

The big picture portrayed in these numbers was certainly not strong. Sam's task was to break the numbers down in order to understand the financial story of one particular wine from one of the particular wineries of the company. Was illosing money? Ifso, where? Was anyone making money on it? How much? How? The inquiry would require tracing the path(s) followed by the 1991 Cimarron Meritage White, from the grape grower all the way through to the final consumer along the Meritage White value chain shown as Exhibit 14.

Chalice Wines 79

THE WINERY

"The vineyard would be the logical place to start, but we're here now, so let's start here. It's simple: I need revenues and costs, starting with cost of goods."

Bill Evanson glanced down at his most recent Report to Stockholders. "No problem. Revenues-$17.3 million; cost of goods sold-$II million."

"It's not that simple, Bill. How much per case of 1991 Cimarron Meritage White?" "I was kidding. Of course we track all of our wines separately. We sell the Meritage White to our distributors

for $76.00/case. As of 12/31192, the wine carried $52.73 in product costs. Here's the file showing where our numbers come from." Evanson gave Sam a thick file folder from his desk.

The file was thick because of the complex production process. Wine isn't produced in a day or even a month. Some wines are effectively "in production" for years, so the various pools of periodic production costs must be allocated among many different wines from different vintage years. CWG's method was as straightforward as possible, given the complexity of the situation. All of the Cimarron Winery's costs were considered product costs and wound up as Cost of Goods Sold for some particular wine. Grape costs were easy to assign directly to particular wines. Winemaking, bottling and bottle aging costs were collected into pools ~d allocated equally to specific wines according to the percentage of the total volume processed. Obviously, only wines tilat were bottled in a year absorbed bottling costs for that year. But all wines held in bulk inventory in a period absorbed their relative proportions of winemaking costs for that period (regardless of what actually happened to the wine) and all wines held in bottled inventory absorbed bottle aging costs. Exhibit 4 shows the yields and the product cost breakdown for the 1991 Meritage White.

Tons Crushed Gallons of Juice Fermented Gallons Aged Gallons of Wine Produced Cases Bottled

Production Cost Grapes Winemaking Bottling Bottle Aging

Total

EXIDBIT4 1991 Meritage White Product Costs

Total $73,901 117,486 93,657

8,937 ~293 981

89.17 14,713 13,984 13,255 5,575

Per Case $13.26 21.07 16.80

1.60 $52.73

Sam Davis knew that eventually each of the components of product cost would warrant further analysis. But, for the purpose of constructing the first level of the value chain profitability analysis, he decided to accept CWG's numbers. The task now was to derive a per case operating profit for this wine, and the per case Return on Assets (ROA). An estimate of per case SG&A expenses was derived by applying the percentage of CWG's sales revenue generated by Cimarron to the total corporate SG&A., then dividing by Cimarron's case sales for the year. A similar approach could be used to estimate the CWG assets employed specifically by Cimarron Meritage White. In 1992 the Cimarron winery sold 37,205 cases for total revenues of $2.7 million with a cost of sales of $2.1 million, and a depreciable asset base of $4.9 million set on 3 acres. Because its bottling line and crushing/pressing equipment were only in operation during a short period each year, overall utilization of these assets was less than 10% of annual capacity.

The profitability analysis for one case of 1991 Cimarron Meritage White demonstrated the contribution or"that wine to the overall financial performance of the Chalice Group according to the cost accounting methods used by the winely. As he went about the task of collecting financial data from other links in the value chain, Sam couldn't help thinking about those product costs that were assigned "equally" to the various wines. If no two wines are the same, then why should they absorb production costs at the same rate? How are they different, and is the difference relevant? He made a mental note to revisit this question once the first level value chain was complete.

80 Chalice Wines

THE VINEYARD

Cimarron Meritage White is a blend of Sauvignon Blanc and Semillon grapes, neither of which is grown at Cimarron Vineyard. All the grapes for this wine are purchased from Pinnacle Vineyards, CWG's partner in the Opera Valley Joint Venture. The price paid in 1991 for both varieties was $812.36/ton (62.42 tons ofSauvignon Blanc and 26.75 tons of. Semi lion). Total hauling costs from Opera Valley to the winery in Sonoma Valley amounted to $1,463. A review of price infolmation published by The California Department of Agriculture revealed that the average price paid per ton for grapes grown in that district that year was $562.50 for Sauvignon Blanc, and $350 for Semillon. Had these prices been paid by CWG the total grape cost, including hauling, would have been only $45,937 instead of $73,901. The potential incremental $5 per case profit led Sam to ask, "Bill, why are you spending so much money on grapes?"

"The simple answer, Sam, is you get what you pay fOf. We don't produce average wines, so we don't buy average grapes. We also consider our contract for these grapes in the context of our long-tenn relationship with Pinnacle and the Opera Valley Joint Venture which is very important to us. But we have to get our costs down, and you've raised a good point. Actually, we've been looking at a 30 acre vineyard in Sonoma County near Cimarron as a potential alternative source of supply. The price is right: $525,000. That's tempting just as a real estate investment. And the land is clearly capable of producing the quality of grapes we need. But since the vineyard has phyIJoxera I) it I,.vould have to be cleared and replanted. So it's tough to say if it would represent a significant improvement on our $13.26/case grape cost. "

Sam began thinking out loud. "I need accurate revenue, cost, and asset information for a typical vineyard to complete that piece of the value chain, and you need to know if it makes sense for you to develop your own vineyard to provide grapes for the Meritage White. Let's kill two birds with one stone. I know that the University of California Extension Service and the Sonoma County Fann Advisor have done a lot of research on vineyard costs. Let's see what they can tell us."

Exhibits 5 and 6 describe the costs and assets involved in the establishment and operation of a 30 acre vineyard . in Sonoma County as of the etid in 1992.

Yield (tons/acre) Total Planting Costs Total Cultural Costs Total Harvest Costs@$120/ton Total Overhead Costs Total Cash Costs Depreciation (see Exhibit 6)

Total

EXHIBIT 5 Costs per Acre to Establish and Operate a Vineyard

Years 1 £ 1-

1.5 5,138 2,440

609 1,062 1,216 180

622 622 642 6,369 4,124 2,038

*$3,598/Acre = $6001T = $9.59/case [62.5 cases per ton]

:! 5 & Forward 3.5 6

1,317 1,317 420 720 698 :ill

2,435 2,755 843 843

3,278 $3,598*

With these cost and asset numbers it was possible to complete a profitability analysis for the vineyard (in full production) in terms of each case of 1991 Meritage White sold. Sam assumed revenue for the vineyard would be $812.36/ton, the price paid by Cimarron to Pinnacle Vineyards. This, of course, assumed production of "better-than­average" grapes.

It should be noted that vineyard profitability is extremely sensitive to fluctuations in grape prices. A ten year history of the weighted average market price paid in California for five leading varieties is shown in Exhibit 7. The Sonoma County average prices are always higher than the state average. The 1992 Sonoma County premium is shown in parentheses for each variety.

1 Phylloxera is a plant IOllse that artacks the roots of grapevines, decreasing yieids and eventually killing the vine. Currently a seriolls problem in California, the only solution for an infected vineyard is to replant on resistant rootstock.

Chalice Wines

EXHIBIT 6: Assets Required to Establish and Operate a 30 Acre Vineyard

Purchase Useful Salvage Annual Investment Price (new) Life Value Depreciation

Land (30 plantable acres) 525,000

Vineyard Establishment (A) 339,374 22 0% 15,426 Reservoir 30,000 30 0% 1,000 Buildings 15,750 30 10% 473 Drip Irrigation System 52,400 25 10% 1,886 Frost Protection System 40,300 25 10% 1,451 Shop Tools 10,000 15 10% 600 Pruning Equipment 1,200 10 10% 108 ATV,4wd 6,500 5 10% [,170 Tractor 29,900 [5 10% 1,794 Duster 3,035 10 10% 273 Mower (B) 5,500 10 10% 495 Orchard Sprayer 4,560 [0 10% 4[0

Weed Sprayer 2,000 10 10% 180 Pickup Truck 16,500 7 10% 2,12[

Total Investment, with new Equip. [,082,0[ 9 27,388 * Allowance for Used Equipment (24,598) (2, [[O)

Total Investment, 30 Acre Vineyard SI,057,421 $25,278

A) "Vineyard Establishment" is the accumulated cash·costs for 1st 3 years, net ofrevcnue earned in year 3 using the price paid by Cimarron in 1991 as a proxy value for each ton produced.

B) Last 6 items can be purchased used@ an average of 60% of new cost. AUowance is made above C'}

EXHIBIT 7 History of California Grape Prices Per Ton

Varicty (*) [983 [984 [985 [986 1987 1988 [989 [990 199[ 1992

Chardonnay (18%) $980 $998 $904 $856 $922 $1,122 $1,225 $1,[28 $1,122 $[,038

Cabemet (32%) $467 $527 $533 $550 $631 $822 $1,032 $977 $918 $872

Zinfandel (56%) $269 $253 $269 $340 $480 $817 $546 $39[ $363 $434

Sauvignon Blanc (35%) $487 $486 $441 $401 $414 $474 $571 $5[8 $541 $552

Semilion (73%) $215 $260 $210 $245 $254 $289 $31 [ $310 $328 $360

* The percentages in parentheses represent the premiums paid to Sonoma County growers over the state averages in 1992.

Although grape cost of $9.59 per case for this vineyard represented an improvement over the $12.99 (13.26-$.27 freight) the winery was paying now, was it a compelling argument for CWG to change it's makelbuy policy on

grapes for this wine? Bill Evanson was pensive. "How should we look at this? I suppose we could plant about half the vineyard to supply the Meritage White at

cost, and the rest to another variety to sell elsewhere. That would lower our product costs at the winery, and possibly .;ene:3te an interesting grape business on the side, provided ',vc can predict whot the mnrkc! will want in future years. In light of our current financial situation, it would be a tricky proposition to present to the Board! The fact is that grape &

81

82 Chalice Wines

wine production is a capital intensive proposition, and the returns just aren't overwhelming. What do the numbers look like downstream in the value chain?"

THE DISTRIBUTOR

Stellar Wines is a typical East Coast wine distributor. Stellar's fmancial statements for 1991 and 1992 are shown in Exhibit 8. In 1992 the company sold 225,000 cases of wine, roughly 50% imported and 50% domestic.

Stellar's product cost for Cimarron Meritage White includes $2.25/case to cover freight from California and state excise ta;< of $ J.56/case. On all premium wines, Stellar's plarmed gross margin percentage was 25%. Operating expenses per case do not vary significantly among the various wines that Stellar sells. From this infonnation and the financial statements, Sam detennined the operating profit and ROA per case of Meritage White sold by the distributor.

ASSETS Cash Accounts Receivable Inventory Equipment (net) Other

Total

LIABILITIES Note Payable, Bank Accounts Payable & Accruals

STOCKHOLDERS' EQUITY Common Stock Retained Earnings

Total

Sales Cost of Goods Sold Operating Expenses Interest Expense Net Income Before Tax

EXHIBITS Stellar Wines Financial Statements

(in Thousands)

Balance Sheets

$ 24 2,273 6,500

108 333

~238

$4,953 1,735

10 2,540 2.55.Q

~

Income Statements

December 31,

Year Ended December 31. 1992

$17,078 12,771 3,394

425 $488

$ 9 1,806 6,592

105 312

~

$4,794 1,544

9 2,477 2,486 ~824

1991 $15,389

11,313 3,187

507 $381

A wine distributor sells wine to both "on-premise" accounts (restaurants, bars, hotels) and "off-premise" accounts (grocery stores, liquor stores, wine shops). The profitability of wine sales in on-premise businesses varies considerably with the type of business and the wine pricing philosophy. Some restaurants mark up a bottle of wine 50 cents, others mark it up 250%. "Typical profitability" is a more meaningful concept when applied to off-premise wine sales. Since most of CWG's off-premise wine sales occur in relatively small premium wine shops, it was decided that this type of business should provide the fmal piece of the value chain.

Chalice Wines 83

THE RETAILER

Riverside Wine Company is one of Stel1ar's best customers. As grocery chains and discount clubs have gained market share, many small premium wine shops have been driven out of business. However, at the top end of the business there remains a demand for service and selection that is difficult to provide in a high volume setting. Exhibit 9 contains selected financial information for Riverside for 1992. As with the distributor, a case is a case. So one way of assigning operating expenses and assets among the cases sold is equal weight. Other approaches are, of course, possible. Sam computed the operating profit and ROA for the retailer as he had for the other players.

EXHIBIT 9 Riverside Wine Company, 1992

Total Sales Cost ofOoods Sold Operating Costs Profit (before tax) Cases Sold Total Assets

OVERALL VALUE CHAIN

$1,889,916 $1,412,000

$438,134 $39.782

14,776 ~719,261 ($235,333 of inventory)

With this last piece of the value chain in place, Sam and Bill stepped back to consider what the numbers meant, and what were the strategic implications for Chalice. Remembering the original question, "Can this be a good business?" Sam put the profitability figures for the four participants in this value chain together to detel1l1ine the overall profit margin and the overal1 return on assets for the industry on every case of 1991 Cimarron Meritage \Vhite sold to consume"rs in retail wine shops.

((Oh well," sighed Evanson, "at least it is a beautiful way of life!" "Yes, but these numbers don't necessarily prove that it can't be profitable. Obviously, some parts are more

profitable than others. But this is only the story as told by your cost accounting methods. Are you confident that those methods provide accurate measures of your costs for individual wines? I have some doubts""

"So do L But the methods are fairly standard for the industry, and the auditors are satisfied. I told you at the outset, every wine is a complex product in the context of a complex product mix. Maybe it is too complex for truly accurate cost accounting."

"Maybe, maybe not. But it's worth a try. The trick is to get your production costs out of the periods in which they happen and into the activities that cause them. Then the activity based costs can be allocated according to the participation of particular wines in each activity. Under the periodic system, a year old wine that sleeps through the following harvest in a barrel still absorbs some of the new costs of crushing, pressing and fermenting: That can't be right. Let's take another look at the breakdown of the product costs for the Meritage White."

WINERY COSTS REVISITED

Sam knew the production cost of $52.73/case from Exhibit 4 was a very crude aggregate average cost. Upon careful reflection, he concluded that the winemaking process can be viewed as involving three distinct stages:

Stage 1 (crushing, pressing and fermenting) Stage 2 (fining, filtering, bulk aging) Stage 3 (preparation for bottling)

But at CWG, all wines shared egually in the allocation of all winemaking cost, based on processing volumes. The 1991 Meritage White was made (crushed, pressed, & fermented) in the fourth guarter of 1991. It was bulk aged for 9 months in 1992, and waS prepared for bottling in the fourth quarter of 1992. Yet this.'V.inf.'s allocation of winema king cost was a simple 7% of the 1991 total and 6% of the 1992 total, based on its share of total volume processed in each year. The

84 Chalice Wines

allocation of $21.07 per case missed all the refinement which an ABC analysis could bring. After a careful review of all cost categories and a careful analysis of activities, Sam prepared Exhibit 10 showing a breakdown of winemaking cost, by stages, for 1991 and 1992, with usage data for the 1991 Meritage White. Based on this exhibit, Sam recalculated winemaking cost for the 1991 Meritage White to be $?

Stage I Stage 2 Stage 3

TOTAL

EXHIBIT 10 Winemaking Cost-ABC Approach*

1991 $285,000 (I)

571,000 57,000

$913,000

1992 $268,000

559,000 (2) 56,000

$883,000

otThe 1991 Mcritage White vintage represented 18% of the wine made in 1991, 15% of stage 2 costs in 1992, and 28% of the wine prepared for bottling in 1992.

(I) Including $12,700 of barrel depreciation, because some white wines are barrel fennented. (2) Including $154,900 of barrel depreciation.

Sam also discovered that the $16.80 per case for bottling was a very simple overall average allocation. He found, for example, that the cost of wooden shipping boxes was allocated across all wines bottled even though Meritage White was shipped in much cheaper corrugat'ed cartons. Meritage White a:lso used cheaper than average bottles and labels. Exhibit II shows a comparison of the average approach and the ABC approach to bottling cost.

EXHIBIT 11 Bottling Cost-Per Case

ABC Cost for Cost Category Average Cost Meritage White

Labor 1.16 .75 Supplies .07 . .07 Bottles 6.43 5.00 Corks 2.39 2.39 Capsules 1.19 1.19 Labels 1.99 1.50 Wooden Boxes .55 0 Taxes 3.02 3.02

TOTAL 16.80 13.92

Third, Sam discovered that barrel depreciation was a very complex issue, involving French oak barrels that had risen in cost from $362 in 1988 to $650 in 1993. White wines are both fermented (three months) and aged in barreis Y'hereas red wines are fermented in tanks. But, red wines are aged 2 years in the barrels versus only nine months for white whites. Yet all barrels at the Cimarron winery are just depreciated, straight-line, over four years, with barrel depreciation as one line item in winemaking cost. Of the $21.07 winemaking cost for the 199] Meritage White, $4.03 (19%) was for barrel depreciation. Sam had no intuition about how a more accurate ABC assignment of barrel depreciation would affect the $4.03 number. Exhibit 12 was constructed to estimate actual consumption of barrel cost, using estimated market values and the actual barrel usage plan for the 1991 Meritage \Vhite.

Chalice Wines

Year Purchased Cost new

Declining Value After 1 year After 2 years After 3 years After 4 years

1989 barrels 1990 barrels 1991 barrels

1988 $362

209 129 67 40

EXHIBIT 12

1989 $418

257 135 76 40

French Oak Barrels 1990' 1991 1992 $515 5539 $608

269 152 81 40

304 163 ? ' 40

325 ? ? 40

1993 $650

American Oak Barrels All years $250

125 63 32 20

(50% of cost of new barrel) (25% of cost of new barrel) (12.5% of cost of new barrel) ($40 imported/$20 domestic)

French Oak Depreciation in 1991

59 (135-76) 117 (269-152) 235 (539-304)

Depreciation in 1992 36 (76-40) 71 (152-81)

141 (304-163)

Fermentation and aging plan for 1991 Meritage White (all French Oak)

Fennent in 25% new barrels, 25% one year old, and 50% two years old. Age in the newest barrels used for fennenting.

Ferment: 92 barrels ITom 1991 (3 months) 92 barrels from 1990

ill barrels ITom 1989 Total 368 barrels' .

• 14,713 gallons ". 40 gals/bbl* ~ 368 balTels «The barrel is only 2/3 filled for femlentation)

Aging: (9 months)

92 barrels ITom 1991 92 barre Is from 1990 49 barrels ITom 1989 233 balTels'

• 13,984 gallons -7 60 galslbbl ~ 233 barrels

BalTel Deoreciation (French Oak) For The 1991 Meritage White Ferment

92 x $235 x 1/4 year ~ 92 x $117 x 1/4 year ~ 184 x $59 x 1/4 year ~

$5405 $2691 $2714

Age 92 x $141 x 3/4 year~ 92 x $71 x 3/4 year ~ 49 x $36 x 3/4 year ~

Total ~ $26,761 ($4.80 per case)

$9729 $4899 $1323

85

As the cost of French Oak barrels had risen 80% in 5 years, Cimarron had decided they needed to at least experiment with American Oak barrels which had stayed at about $250 throughout. But the winemakers felt sure that French oak imparted better taste to the wine. Sam prepared the following summary table comparing barrel depreciation cost for various costing options:

Average costing ABC approach (3 stage costing)

Barrel Depreciation Cost Per Case (1991 Meritage White)

"Declining value" depreciation with actual barrel usage: French Oak barrels Domestic Oak barrels

Replacement cost depeciation

$4.03 ?

$4.80 ? ?

86 Chalice Wines

Based on his revised calculations, Sam now estimated the product cost of the 1991 Meritage White, for strategic assessment purposes, as ? per case. He adjusted the overall value chain accordingly_

LYFORD WINERY

As one example of a very different approach to the value chain, Sam was aware of Lyford Winery which had been founded in Sonoma County in 1981. It was constructed as a state of the art winemaking showplace with no expense spared in either the production of the wines or in the effort to build the brand in the marketplace. After the untimely death of the founder, the company was sold to a consortium of several other winery properties which ultimately failed. The winery was sold out of bankruptcy to another California wine company. The brand name was sold to a French company. Wine for the brand was sourced from the bulk wine market. Processing services were purchased from custom suppliers under the direction of the original winemaker who was retained by the French company.

Exhibit 13 gives the per case cost structure for one of Lyford's more recent releases, a 1991 Meritage White. The wine was a blend of three different varieties, each purchased on the bulk market. The final blend was 85% Sauyignon Blanc. l3% Semillon, and 2% White Muscat.

EXHIBIT 13: 1991 Lyford Meritage White

Product Costs per Case

Bulk Wine Cost Bottling Corks Capsules Labels BOltles Lyford Overhead & Supplies Wine Tax

Total

$ 9.26 2.28 2.37 1.16 0.70 4.60 2.02 3.02

$25.41

The product costs shown in this exhibit tell nearly the entire story of this wine. The "winery" has virtually no capital assets beyond leased office and warehouse space and working capital (assume 30% of sales). All of the services required to bring the product from the bulk wine market to distribution can be purchased either from wineries with surplus capacity or from custom winemaking operations. An allocation of marketing expenses added only about $1.09 to the per case cost of the wine. Leased space and equipment added about another $5 per case.

Lyford sold the wine to wholesale distributors for $45.00 per case, with a target retail price of$7.50 per bottle.*

* Lyford Winery-The Value Chain Sales Costs Margin Assets ROA

Price to Distributor + Freight & Taxes Delivered

Price to Relailer (.;. .75)

Price to Consumer (.;. .75)

4S ? ? ? ?

45.00 + 3.81 = 48.81

= 65.00

= 86.67 =-7.22/BottJe (-$7.50 with sales tax)

Sam knew the Chalice ~,'illdlldk.er$ would totally reject this "bogus" approach to "winemaking." But somebody

Chalice Wines 87

was buying the wines and apparently enjoying them. Sam had to admit that even he thought the 1991 Lyford Meritage White showed very well in tastings. Could Chalice learn anything from the Lyford story?

QUESTIONS

1. First fill in all the relevant calculations discussed in the case but left blank. 2. Then pull together an overall value chain for the project using the fonnat shown here (Exhibit 14). 3. What business issues are raised by the case? 4. What inferences for CWG do you draw from the Lyford wines value chain? 5. What advice do you have for Sam Davis and Bill Evanson regarding the 1991 Cimarron Meritage White? For

the CWG business as a whole? •

Vineyard Revenue Operating costs Margin Assets

Winery Revenue Costs

Grapes Winemaking Bottling Bottle Aging SG&A

Margin Assets

Distributor Revenue Wine Cost Operating Cost Margin Assets

Retailer Revenue Wine Cost Operating Costs Margin Assets

Revenue Profit Assets

EXHIBIT 14 The Value Chain-1991 Cimarron Meritage White

(per case)

+$.27 handling cost

+ $2.25 freight + 1.56 tax

The Overnll Value Chain

PIS = D S/A =

ROA=

PIS = D S/A = ROA=

PIS = D S/A= ROA=

PIS = S/A= ROA=

PIS = D S/A =

ROA=

CHILD'S PLAY COMPANY (C)

This case uses the data provided in Child's Play Company (A) and (B). Assume that the company decided to follow Plan A for 2011. The CFO, Don Capp was assembling data in November 2010 to prepare a budget for 2011.

The sales department had indicated that the expected pattern of sales was as follows: 20 percent of the sales in the first quarter, 30 percent in each of the next two quarters, and 20 percent in the last quarter.

It was hard to figure out the sales by month -- the best assumption was that sales would be spread out evenly by month within each quarter.

The promotional materials would be supplied to retailers in January.

The production department planned to maintain as the finished goods inventory enough inventory for the following month's sales. However, the December 2010 finished goods inventory was expected to be only 20,000 rattles, and the December 2011 finished goods inventory was planned to be equal to December 2011's sales (since January 2012 expected sales was not yet known).

Don Capp also knew that several of the company's policies would continue into the next year:

I. Child's Play generally sells to retailers on two month's credit. The beginning balance in accounts receivable at the start of the year was expected to be $400,000, of which half would be collected in January 2011, and the remainder in February.

2. Raw materials and packaging materials are purchased one month ahead of their use. The company makes the purchase on one month's credit.

3. All costs (other than materials) are paid for as incurred.

4. The fixed manufacturing costs include $80,000 of depreciation expense. Fixed selling and administrative costs include $40,000 of depreciation. The rest of the costs relate to rental costs, property taxes and salaries and are paid monthly.

5. The company generally maintains a cash balance of about $10,000. If the balance drops below that amount, the company will take a short term loan from the bank. (Ignore interest.)

Required

Prepare a cash budget for each month for the first quarter of 20 II. In order to prepare this budget, you will need first to prepare a production schedule. Ignore income taxes.

3

KIWI COMPANY

Kiwi Company produces automobiles. It had budgeted sales and production of 10,000 cars for 2010 at a selling price of $5,000 each. The company had budgeted the following costs for 2010:

Standard Variable Manufacturing Costs per unit Fixed Manufacturing Overhead for year Selling and Admin Costs:

Variable (per unit) Fixed (total for year)

$4,000 $3,000,000

$500 $1,000,000

The company actually sold 11,000 cars for $4,800 each. Suppose that at the end of the year the financial results for the period are:

Variable Manufacturing Costs Variable Selling and Admin Costs Fixed Manufacturing Costs Fixed Selling and Admin Costs

$46,000,000 $3,500,000 $2,000,000 $1,200,000

1. What were budgeted profits for the year? What were actual profits for the year? What was the overall variance in profits for the year? Did the company overall perform better or worse than expected?

2. Compute total master budgets and actual results for:

(a) revenues (b) variable manufacturing costs (c) variable selling and admin costs' (d) fixed manufacturing costs (e) fixed selling and admin costs Which line items were responsible for the overall profit variance?

3. Compute flexible budgets for:

(a) revenues (b) variable manufacturing costs (c) variable selling and admin costs' (d) fixed manufacturing costs (e) fixed selling and admin costs

4. Compute selling price and volume variances for revenues.

5. Compute volume variances and combined price/efficiency variances for variable costs.

6. What is the volume variance for fixed manufacturing costs?

7. Kiwi has two responsibility centers: production and sales departments. Production department is responsible for efficiently purchasing for and producing the necessary amount of production. Sales department is responsible for pricing and therefore the amount sold, as well as for controlling selling and administrative costs. Which combination of variances would you use to evaluate the two departments? Which variances would you view as uncontrollable? Each year a cash bonus of $1 ,000 per person is paid to all the individuals in the department (production or sales) which performed most above expectations. Which department will receive the 2010 bonuses?

2

...... DARDEN fri1i1i UVA-C-2059 BUSINESS PUBLISHING

UNIVERSfIYifVlRGlNIA

BA Y INDUSTRIES

Jim Quick, president of Bay Industries, was beginning to draw some conclusions in January 2002, as he listened to a presentation by Ben Robinson, one of his three division managers.' Within a week, he would have to guide a series of decisions on divisional and corporate strategy and determine each division manager's bonus. About half of each bonus was computed automatically from profits and performance to budget, but the other half was based on his evaluation of the division manager. On the one hand, Quick was glad to have the opportunity to apply his own judgment because he had never quite trusted the numbers to give a reliable reading. On the other hand, he knew that his unsupported judgment could be perceived as arbitrary.

Control Devices Division

Robinson had managed the Control Devices Division for three years, and it had done reasonably well, although profit in 2001 was down slightly from the previous year. At the moment in his presentation, Robinson was talking about some guy in the South Pacific named Ona. He called Ona a mystic who had made ·Iife difficult for his division. He said Ona had caused Papua New Guinea's Bougainville copper mine, one of the world's largest, to shut down in mid-2001, thereby pushing up the price of copper just when he needed to buy. Quick remembered an article about it in the Wall Street Journal a few days before, with the headline "An Audacious Rebel in Papua New Guinea Shakes Copper Market."

The Control Devices Division made machine controllers for large specialized installations, as well as numerous smaller installations, in the chemical, paper, and petroleum industries. In the mid-1970s, the division had developed and patented an electromechanical­thrust-transmission device that had helped it achieve a large market share. In the last two decades, electronic components had been added to help maintain the company's competitive position.

Earlier in his presentation, Robinson had noted that competition came from unexpected sources. Two months earlier, the division had lost Denmark as a large customer. His European

This case was prepared by William Rotch and revised by Luann Lynch, Assistant Professor of Business Administration. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright © 1990 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies. send an e-mail tosales@dardenpublishing.com. No part oj this publicaNon may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means-electronic, mechanical, photocopying, recording, or otherwise-withollt the permission of the Darden School Foundation. Rev. 5/04. 0

-2- UVA-C-2059

representative had told him that the division's price had been low enough to get the business, and hinted at some under-the-table deal by the German company that won the bidding. Because about one-third of the division's sales were in Europe, Quick wondered what the implications of this event might be. Robinson had said little about it except that it had clobbered his bottom line.

Cookware Division

Colin Wood's report on the Cookware Division documented remarkably consistent profits and a high return on investment during his two years as manager. The division made ceramic cookware that could go from the oven to the table. Most sales were through mass merchandisers like Kmart. The item was not branded and depended on good design and wide distribution to maintain sales volume. The business was competitive, but Wood had shown a good sense of what would sell in each distribution channel and geographical area. He previously had been division director of Marketing and had been promoted when his predecessor left to head a larger operation in another company.

While listening to Wood, Quick remembered that the division's Christmas sales had benefited when a major competitor was shut down for two months to bring itself into compliance with environmental-protection standards. Quick was glad that Bay Industries had installed the necessary screening devices three years ago.

Wood had noted in his report that two of the divisi.on's three melting tanks and most of the forming machines were 10 years old and in need of replacement. In his long-term capital forecast, submitted in both 2000 and 2001, he. had estimated that $60 million to $80 million would.be needed to purchase the new equipment.

Electronics Division

Martha Hadley's report on the Electronics Division revealed a disturbing, consistently low rate of profit. Hadley had taken over the moderately profitable division three years earlier. At that time, the division's main product had been an automatic-frequency-control CAFC) component that went into many radios and television sets. After joining the division, Hadley had designed a similar component \hat could be effectively used in cordless and cellular telephones. Sometimes the compol)ent was built into the telephone, and sometimes it was part of the installation. The division's competitors are mostly larger companies, but Hadley had been able to break into the phone market by having a six-month lead with a superior product.

Hadley said that the only way to succeed in the business was to keep a jump ahead of everyone else. She gave as an example the time earlier in the year when she had recognized that fast delivery was crucial to getting the order in about a third of the phone-component business. Not only was speed important in some orders, but also precise delivery time was required by almost all customers to keep their inventory down; many customers used just-in-time

-3- UVA-C-2059

manufacturing systems. Hadley's competitors had regional warehouses, allowing them to delivel: overnight to most places. So, she had arranged with an express-service finn to deliver fast and reliably, usually by air. Sometimes, when delivery was a week or more away, air freight was not used, but the carrier's delivery could still be .timed to within three hours. Hadley believed the key was reliability and that the higher direct cost per shipment would be less than the cost of warehousing. Her volume was rising, but her costs had not gone up as much.

Hadley estimated that her share of the radio AFC market was about 10 percent, and that her share of the newer telephone-frequency-control market was nearly 25 percent and holding steady as the market continued to grow. She had invested in new equipment in 2001 to be able to service the growing phone market and capture economies of scale.

Bonus

Jim Quick reviewed the financial results of each division (see Exhibits 1,2, and 3) to see how the division managers' bonuses would come out. The 2001 bonus pool for these three managers amounted to $100,000, which was based on overall corporate profit. The bonus plan currently in force directed that half the pool be distributed on the basis of points and half on the basis.of the president's judgment.

Points were awarded in two ways, both based on the percentage return on capital employed (ROCE). The first way gave one point for each percentage point that actual ROCE was above planned ROCE minus 5 percent. This method allowed a manager to receive a bonus even if the division did not achieve the projected figures. (The planned figures were the result of a budgeting process that started in the divisions and ended with a discussion or negotiation between Quick and each division manager.) In the second way, one point was awarded for each I percent that actual ROCE was above the average of the previous two years. Following those rules, Quick computed the bonuses:

Ben Robinson, control devices Colin Wood, cookware Martha Hadley, electronics

First Method I

12 2

Second Method o 7

2.5

Total Points I

19 4.5

Bonus $ 2,040

38,760 9,180

$49,980

As he pondered these results, Quick wondered whether they represented proper rewards for the results achieved. He also wondered whether this part of the bonus system was as good as it could be. Because Quick was to use his own judgment in the second part of the bonus system, if he did not like the way the first $50,000 was divided, he could remedy the situation-at least partially-by dividing up the remaining $50,000.

-4- UVA-C-2059

Investment Proposals

The following brief summaries follow a proposal for capital expenditures, in 2002 and after, that were submitted by each division.

Control Devices Division

In sUbmitting his proposal, Robinson noted that he had unused capacity. Normally, using that capacity would not require new investment, but in this case, he said he had an opportunity to pursue a special contract, which would be worth about $10 million in sales in 2002, ifhe could purchase two pieces of automatic equipment for $2 million. Although the machines would require some unique programming, he was intrigued because one of the machines used a control device produced by the division. They were, of course, accustomed to programming their own devices, but they had not worked with this application, and he hoped to learn from it.

Noting that the investment would produce a high rate of return, Robinson submitted the following pro forma for the contract:

Revenue

Costs:

Total cost Profit

Material Labor Overhead Distribution

Cookware Division

$10,000,000

5,200,000 1,600,000 1,400,000 (includes only variable overhead)

200,000 8.400,000

$ 1,600,000

Wood submitted a proposal for replacement of the two aging melting tanks and the forming equipment. The tanks had been installed 10 years before at a cost of about $14 million; replacement would cost about $30 million. The repair cycle for the tanks had started at 18 months but had been shortened to 10 months. Wood noted that, although the technology had not changed much, the new tanks would be more flexible and somewhat more efficient in the use of energy. He also noted some concern about the safety of the aging tanks.

The forming machines were also about 10 years old and required an increasing amount of maintenance. New forming machines would cost about $30 million to $40. million. Again, the technology had not altered, but the new machines could be changed over faster, accommodated a greater variety of molds, and included a quick replacement system for molds that wore out with regularity. Quality would be more consistent with the new machines, and overall capacity would increase about 20 percent, half of that from the expected decline in rejects.

-5- UVA-C-2059

Wood advised replacing the tanks within a year and the forming machines within two years. If the two replacements were done at the same time, however, about $10 million would be saved.

Electronics Division

Hadley's investment proposal was for additional capacity to enable an increase in output of 25 percent. She expected to continue serving the expanding telephone market, with its continual demand for refined product designs. Hadley requested $16 million for equipment and facilities and $4 million for networking capital, for a total of $20 million. She submitted the following pro forma, showing the projected increases in revenue and expenses:

Revenue Material Labor Other conversion Total Margin New-product development Marketing Distribution Administration Corporate Total, other costs Net profit

(millions)

$40.0 21.0

5.0 4.2

30.2 9.8 2.8 1.4 2.0

----.M

~ $3.2

-6- UVA-C-2059

Exhibit 1

BAY INDUSTRIES

Control Devices Division (000,000)

1999 2000 2001 Income Statement Plan Actual Plan Actual Plan Actual Sales $154.0 $154.4 $160.0 $163.6 $166.0 $152.0 Manufacturing cost

Material cost 80.0 84.4 77.4 Conversion cost:

Labor 20.2 19.6 17.6 Overhead 23.2 27.6 27.6 Total cost 123.4 131.6 122.6 Margin 31.0 32.0 29.4

Other costs New-product development 4.2 4.6 3.8 Marketing 4.4 4.6 4.0 Packing and distribution 2.6 3.0 3.0 Administration 1.8 2.2 2.8 Corp. for divisions 1.2 -.lA -1Jl. Total other 14.2 15.8 15.4

Net division profit $16.0 $16.8 $16.4 $16.2 $16.8 $14.0

Balance Sheet Accounts receivable $25.8 $27.4 $25.4 Inventory 20.0 21.0 23.8 Plant and equipment cost 72.8 76.6 84.0 Accumulated depreciation 38.2 44.2 51.2 Net plant and equipment 34.6 32.4 32.8 Total assets 80A 80.8 82.0

Current liabilities 22.4 23.0 24.4 Capital employed $60.0 $58.0 $60.0 $57.8 $60.0 $57.6 Return on capital employed 27% 29% 27% 28% 28% 24%

-7- UVA-C-2059

Exhibit I (continued)

Notes on the Divisional Financial Statements

I. The expense labeled "Corp. for divisions" represented an allocation of corporate expenses that were believed to benefit the divisions directly. Other corporate expenses, totaling about $10 million, were not allocated to the divisions. The three divisions represented substantially the whole of Bay Industries' business.

2. The division balance sheets were somewhat abbreviated. Cash was not allocated to divisions. Also, other corporate assets, amounting to about $14 million, were not represented on the divisional balance sheets.

3. Divisional current liabilities were mostly trade payables.

4. Corporate income taxes were not allocated to the divisions.

-8- UVA-C-2059

Exhibit 2

BAY INDUSTRIES

Cookware Division (000,000)

1999 2000 2001 Income Statement Plan Actual Plan Actual Plan Actual Sales $110.0 $110 .. 2 $116.0 $120.4 $126.0 $140.6 Manufacturing cost

Material cost 20.0 22.6 28.8 Conversion cost:

Labor 28.2 31.8 39.4 Overhead 36.0 37.2 37.8 Total cost 84.2 91.6 106.0 Margin 26.0 28.8 34.6

Oiher costs New-product development 1.0 1.2 1.2 Marketing 6.2 6.6 7.2 Packing and distribution 7.8 8.2 9.8 Administration 1.0 1.4 1.6 Corp. for divisions 0.8 ~ --1.§. Total other 16.8 18.4 21.4

Net division erofit $8.0 $9.2 $9.8 $10.4 $11.0 $13.2

B llance Sheet Accounts receivable $13.2 $15.0 $17.0 lnventory 1.6 1.8 2.4 Plant and equipment cost 39.4 43.6· 48.0 Accumulated depreciation 28.6 32.4 36.6 Net plant and equipment 10.8 11.2 ill Total assets 25.6 28.0 30.8

Current liabilities 2.2 2.4 3.0 Capital employed $22.8 $23.4 $25.8 $25.6 $27.4 $27.8 Return on capital employed 35% 390/0 38% 41% 40% 47%

-9- UVA-C-2059

Exhibit 3.

BAY INDUSTRIES

Electronics Division (000,000)

1999 2000 2001 Income Statement Plan Actual Plan Actual Plan Actual Sales $86.0 $90.4 $116.0 $111.8 $140.0 $146.6 Manufacturing cost

Material cost 52.2 61.0 75.4 Conversion cost:

Labor 10.8 14.8 18.8 Overhead 9.0 14.4 17.2 Total cost 72.0 90.2 ll.L± Margin 18.4 21.6 35.2

Other costs New-product development 6.0 6.4 9.8 Marketing 2.4 3.0 4.6 Packing and distribution 3.0 4.0 8.2 Administration 1.6 1.6 2.2 Corp. for divisions 0.8 ...LQ il Total other 13.8 16.0 26.6

Net division profit $4.0 $4.6 $6.0 $5.6 $8.0 $8.6

Balance Sheet Accounts receivable $12.6 $J5.2 $J9.8 Inventory 10.6 12.2 J4.2 Plant and equipment cost 45.8 52.2 68.6 Accumulated depreciation J 9.6 24.4 29.6 Net plant and equipment 26.2 27.8 39.0 Total assets 49.4 55.2 73.0 Current liabilities 14.4 19.4 22.4 Capital employed $26.6 $35.0 $35.2 $35.8 $40.0 $50.6 Return on capital employed J5% 13% 17% 16% 20% J7%

HARVARD BUSINESS SCHOOL

9-101-038 REV: MARCH 9, 2004

ROBERT S. KAPLAN

Software Associates

Susan, I have just seen the quarterly P&L. It's great that we exceeded our billed hours and revenue targets. But why, with higher revenues, is our bottom line less than half of what we had budgeted. Can we have a meeting tomorrmv morning at 8 Alvl so you cnll explain this discrepal1cy to me?

- Richard Norton, CEO of Software Associates

Norton, the founder and CEO of Software Associates called Susan Jenkins, CFO of Software Associates, after skimming the second quarter profit and loss statement (see Exhibit 1). Jenkins had been preparing to go home but now anticipated a long evening ahead to prepare for the next morning's meeting.

Assignment Question 1: Prepare a variance analysis report based on the information in Exhibit 1. Would this be sufficient to explain the profit shortfall to Norton at the 8 AM meeting?

History

Richard Norton had founded Software Associates ten years ago to perform system integration projects for clients. While initially set up to operate in client-server environments, Norton had been nimble enough to make the transition to web applications, and his company had continued to grow and prosper during the rapid technological evolution of the 1990s.

Annual revenues exceeded $12 million, and profit margins were usually between 15% and 20%. Currently, Software Associates offered two types of services to clients. The Solutions business helped clients rapidly develop targeted information management strategies, and then mobilized business and technology resources to deliver software solutions. Typical services included IT strategy and management, IT architecture and design, information management, and data warehousing. The Contract business offered clients experienced software engineers, programmers, and consultants, on a short-term project basis, to help the clients implement their own IT tools and solutions. This service enabled clients to implement major IT projects without having to hire expensive, experienced software personnel.

Professor Robert S. Kaplan prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

Copyright © 2000 President and Fellows of Harvard College. To order copies or requcst permission to rcproduce materials, call 1·800·545·7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.cdu. No part of this publication may be reproduced, stored in a retrieval system, u;'l!d JI\ a sprcadshect, or transmitted in any fonn or by any means--electronic, mechanical, photocopying, recording, or othenvise-without the permission of Harvard Business School.

101-038 Software Associates

Preparing the Budget

Each quarter Norton and Jenkins prepared a detailed budget for the next three months, based on the annual plan, and recent operating experience and information from the market. Norton knew that in his fast-paced business, he could not manage with just an annual budget. He wanted to continually scan the environment and industry trends before locking into a hiring plan, an operating plan, and a budget for a period. For the quarterly budget, Jenkins estimated consulting revenues by multiplying together the expected number of full-time-equivalent (FTE) consultants at the firm, the number of hours available (450 per quarter) per FTE, the expected billing percentage (the ratio of hours billed to total hours available), and the average hourly billing rate. She calculated consultant expenses by multiplying the average compensation (including fringe benefits) per consultant by the number of FTE consultants. She then estimated operating expenses such as advertising, administrative support, education and training, information systems, occupancy, office expense, postage and telecommunications. Exhibit 2 contains the budget and the actual financial results for the second quarter of 2000.

Assignment Question 2: Prepare a variance analysis report based on the information in Exhibit 2.

Expense Analysis

Jenkins knew that the budgeted operating expenses were neither entirely variable nor entirely fixed during the quarter. Some expenses varied during the quarter based on the number of consultants hired and working, while other were" fixed," independent of the number of consultants on board. ObViously, consultant expense varied with the number of consultants hired. Occupancy expenses, however, were fixed through the quarter unless she authorized the acquisition or rental of additional space. Expenses such as computing and telecommunications had both fixed and variable components. Because of the profit shortfall in Q2 2000, Jenkins knew that she had better be prepared to explain to Norton why expenses had exceeded the budgeted amounts. During the evening, she spent several hours studying the operating expense categories, eventually preparing Exhibit 3, which showed budgeted operating expenses by category and her judgment about their degree of variability. She also listed the actual operating expenses for the period on the exhibit.

Assignment Question 3: Prepare a spending and volume variance analysis of operating expenses based on the additional information supplied in Exhibit 3.

Billing Percentage

Jenkins wondered why if the actual number of consultants was nearly 8% higher than budgeted (see Exhibit 2), revenues had increased only 1%. Were consultants becoming less productive? She knew that a key operating statistic for consulting organizations was the percentage of time billed.

Assignment Question 4: Prepare an analysis of the revenue change, separating the volume effect (increase in number of consultants) from the productivity effect (billing percentage).

2

Software Associates 101-038

Lines of Business

Jenkins was, by now, getting quite tired and was looking forward to returning horne to catch a few hours of sleep. As she prepared to leave, however, she realized that Exhibits 1 and 2 only reported on the aggregate financial performance of the firm. She knew that its two lines of business, Contract and Solutions, had quite different operating characteristics. Typically Richard Norton didn't want to get too involved in the details of these different business lines. But perhaps some of the dedine in profit margin and lower revenue per consultant could be attributed to operating results within each of the two lines of business. Jenkins reluctantly returned to her desk and started to gather more detailed information about the Contracting and Solution business lines. Several hours later, she had produced the data shown in Exhibit 4.

Assignment Question 5: Prepare an analysis of actual versus budgeted revenues, consultant expenses, and margins using the additional information supplied in Exhibit 4.

Additional Analysis

Jenkins was finally driving horne at 2 AM. She felt well equipped for the meeting the next morning but wondered about other forms of analysis she might have done if she had more time. For example, Norton had been quite pleased with the growth in revenues and billed hours. But was that due to good work by the firm, or had the overall consulting industry grown faster than expected during the quarter. In other words, was Software Associates increasing or decreasing its share of software consulting business? Also, Jenkins had assumed that operating expenses varied only with the number of consultants. She pondered whether the consultants from the Solutions business required more support than did the consultants in tl,. Contract business. Also, did support expenses vary with the number of consultants, of either type, or with the number of hours they worked or billed? Within each business line, she had used an average billing and cost rate per consultant. Would she get additional insights by looking at the mix of consultants used within each business or even on each job to understand better the economics of the business. She resolved to think more about these issues in the upcoming quarter, but her most urgent task was to get some sleep before presenting her analysis to Richard Norton in a few hours.

3

101-038 Software Associates

Exhibit 1 Software Associates Income Statement, Q2, 2000

Actual Budget

Revenues $3,264,000 $3,231,900

Expenses 2,967,610 2,625,550

Operating profit $296,390 $606,350

Profit percentage 9.1% 18.8%

Exhibit 2 Budget and Actual Income Statement: Quarter 2 2000

Actual Budget

Revenues $3,264,000 $3,231,900 Less:

Consultants' salaries and fringes $2,029,050 $1,748,250 Operating expenses 938,560 877,300 Total expenses $2,967,610 ~2,625,550

Operating profit $ 296,390 $ 606,350 Profit % 9.1% 18.8%

Operating Statistics Number of consultants (FTE) 113 105 Hours supplied 50,850 47,250 Hours billed 39,000 35,910 Average billing rate $83.69 $90.00

4

Software Associates

Exhibit 3 Expense Items: Budget Q2 2000

Actual Budget % Variable

Advertising and promotion $22,100 $15,100 0%

Administrative and support staff 225,000 191,250 80 Information systems 126,200 . 120,000 80 Depreciation 23,400 22,700 0 Dues and subscriptions 11,800 13,100 80 Education and training 36,200 38,900 80 Equipment leases 23,500 22,440 25 Insurance 33,600 32,200 0 Professional se/Vices 39,500 34,700 0 Office expense 42,100 36,550 100 Office supplies 86,200 89,600 80 Postage 27,300 24,700 80 Rent - real estate 117,260 117,260 0 Telephone 40,000 38,500 100 Travel and entertainment 57,800 56,300 100 Utilities 26,600 24,000 25

Total $938,560 $877,300

Exhibit 4 Line of Business Budget and Actual Operating Statistics: Q22000

Contract Solutions Total

Actual Number of consultants (FTE) 64 49 113 Billed hours 24,000 15,000 39,000 Billed revenues $1,344,000 $1,920,000 $3,264,000

Hours supplied 28,800 22,050 50,850 Consultant costs $1,036,800 $992,250 $2,029,050

Budget Number of consultants (FTE) 56 49 105 Billed hours 20,160 15,750 35,910 Billed revenues $1,088,640 $2,143,260 $3,231,900

Hours supplied 25,200 22,050 47,250 Consultant costs $756,000 $992,250 $1,748,250

5

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Chaparral Beef

Shaun Andrikopoulos, John K. Shank Dartmouth College

It was a hot June afternoon when Junior Wells pulled his Ford pick-up into the Chaparral Ranch near Greeley, Colorado. He had been on the road for three days, returning from his first year at a prestigious eastern business school. Junior had

been unable to find an exciting summer job and he was unwilling to take a "me too, cookie cutter" job. As always, he could rely on his father's feedlot for summer employment. Junior was not looking forward to spending a hot summer riding pens and feeding cattle, tasks he despised. Like most people in his generation from farm backgrounds, Junior had little or no interest in pursuing an agricultural career.

As he entered his father's office he noticed large piles of feed slips, cost reports, financial statements, and industry periodicals. Junior's father was on the phone negotiating calf prices with a stocker in Wyoming, "Buddy, I know you have fine Angus cattle, I just can't pay you more tl,an the market rate for calves that will only bring me market averages when I sell them." Buddy Guy, the rancher, had sold calves to Chaparral for ten years on a spot basis. Although both Guy and Wells had reduced shipping and selling costs through their relationship, neither had explored a long term pricing agreement. Fred dealt with about len ranchers on a similar basis.

After getting offthe phone, Fred began discussing Junior's trip and his first year at . business school. Then the phone rang again, "Howdy, Johnny." Johnny Winter, a local cattle buyer for the Monfort Packing plant, was calling to schedule a time to look at five pens of cattle that Fred had recently announced were ready to ship. "Yeah, seven thirty should be fine, but I need to finish by eleven so that I can get over to the sale bam to see how the feeders are selling." Fred's Wednesday schedule was now packed.

No sooner had Junior and Fred resumed their conversation when the phone rang again, "Yes, this is Fred. A water line broke this morning, and we need it fixed by tomorrow for a pen of cattle coming in from California. Can you do it?" Fred had spent a good part of his day dealing with a broken water line instead of going to a

------_ .. _----_.-;-:---;-;-; This case was written by Shaun AndrikopouJos under the supervision of Professor John K. Shank of Dartmouth College as a basis for classroom discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 1996 by South-Western College Publishing.

ISBN 0-538-88964-0. For information regarding this and other CaseNet'" cases, please visit CaseNet® on the World Wide Web at casenet.thomson.com. CaseNet® is a registered service mark used herein under license.

2 ........... . CaseNet0

Chaparral Beef © South~Western College Publishing

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local seminar on intensive feeding practices. Fred, instead, sent his cattle operations manager, Lonnie Mack, to attend the presentation.

1 can't believe how much time you spend on the phone, Dad I've been here /ol"ly­five minutes and haven', spoken to you Jor ten.

f know, I just can 'f keep my head above waler long enough to spend any time re­viewing my monlhly callie pel/ormance, Fred continued, I know I spend 40% of my time dealing with these damned cutthroat buyers. I spend another 20% oj my time buying calves and fussing with the stocker farms, like Buddy's.

By the way, how is Buddy doing? asked Junior.

The drought hit him harc!, but his callie are lop notch. I'm almost positive that his steers outperform the rest of my animals. I just don 'f have lime to go through my slaughter receipts 10 verifY that they are doing better. Buddy keeps bugging me about paying him a premium. / glless I just can 'I look into everything! J know how he feels because 1'111 sick and tired of bickering with the packers over the quality of my cattle. The buyers all know Ihat my cattle are better than most, but aliI get is spot price pills whatever I can "negotiate" oul of Johnny or the buyers I deal with /rom the other packers. Besides, Monfort is only two miles down the road I know they save a hell of a lot on shrinkage and shipping compared to when Excell bllYs Fom liS." (Excell Beefis located in Sterling, Colorado, 50 miles away.)

CHAPARRAL OPERATIONS

The Wells feedlot has an annual capacity of about 60,000 head. With an average holding period of 196 days, this would be about 32,000 head at anyone time. Wells is currently holding around 28,000 cattle, 18,000 of which are finish ration cattle. On average, the cattle are switched fi'om low to high ration after about 88 days (at a weight of about 1000 pounds).

Pens. Most "efticient" feeder ranchers maintain pens of about 300 cattle. Studies have determined that pens should be designed to provide 160 sq. ft.lhead for sleeping, standing, and exercising. Cattle require 24 inches of bunk space per head ,vhen feeding. Each pen is about 49,000 square feet (650' 075').

Pens are deaned every six weeks. Maintaining clean pens, especially in wet months, is essential in preventing respiratory and other disease problems. A full time crew of two men cleans the pens while the cattle are in them. Manure is COllected, loaded on spreader trucks, and spread on nearby fannland for fertilizer. The cleaning crew is also responsible for emptying and washing feed bunks in each pen.

Feeding_ Like most large commercial feedlots, Fred Wells feeds his animals once a day. Feeding occurs all day because cattle are awake during daylight hours and prefer to eat when it is light. Cattle fed in the morning will tend to "rush" the feed bunks because they are hungry. In summer months, cattle tend to eat only in the morning and in the evening, when the temperatures are below 80 degrees.

Every day, "pen riders" ride the pens to monitor feed consumption patterns. Excess feed in the bunks prior to feeding indicates that the animals are being overfed. EmptyJ?!~n~3 indicate underfeeding . .A. "leftover" estim~te.~~_~:.agebLthe riders and.is_ entered into a computer which helps the feedmill operators calculate the daily ration for each pen. Feed that is left in the bunks overnight usually goes to waste because it

ISBN O·53B-llB964-O <Q South~Western College Publishing

Shaun Andrikopoufos, John K. Shank

loses its flavor and aroma, In the summer, leftover feed mildews in the bunks and creates additional respiratory problems in the herd, In winter months, leftover feed is inedible because it freezes solid in the bunk,

Feed drivers start their nine-hour shift before the sun begins to heat the day, Each truck requires one operator. On-board scales must be calibrated each day on each truck, After calibration, the trucks are loaded with feed ration and additives and are weighed prior to mixing, It takes about two minutes to load each truck, Although the ration has been pre-mixed, additives must be mixed into the main ration, On-board mixers are operated for about four minutes while the truck sits idle,

After mixing, the feed is driven to the pens. On average, a round trip takes about fourteen minutes and is about 3+ miles in length, The trucks drive alongside the feed bunks and deliver even amounts of feed from a mechanized conveyor which unloads from the bottom of the truck's hopper. "High ration" cattle are fed first, "low ration" cattle second, and hospital pens and special pens third, At the end of each day, the trucks are cleaned and then serviced by the full-time mechanic,

Feed rations are carefully calculated for each group of cattle (starter, intermediate, and finish) based on their growing cycle requirements, consumption patterns, and the nutritional value of the feed, Two full-time feedmill operators calculate the feed rations each day, The mill operators are accountable for every pound offeed, Rations are recalculated each day, The operators process, blend, and load each truck, Weekly samples are submitted to a professional laboratory for complete nlItritional analysis,

The Feed Operations Manager is responsible for supervising the feedmill operators, monitoring waste in the feed bunks on a daily basis, and handling all purchases, shipping, and inventory management.

Starter and' intermediate cattle consume an average of 19,2 pounds of ration per day (La ration), while finish cattle average 3 I pounds per day (Hi ration), Animals coming from stocker operations usually weigh around 750 pounds when they enter the lot and are slaughtered at about 1300 pdlmds. Weanling calves that enter the feedlot directly from cow-calf operations could also be purchased, They weigh about 500 pounds and are slaughtered at about 1050 pounds, Wells is not currently using weanling calves,

Equipment. Feedlots utilize hopper trucks that are loaded from an overhead grain conveyer. Fred Wells uses 340 cu, ft. trucks that cost around $40,000 and haul 10,000 pounds of feed per load, On larger operations, where reliability is important, trucks are sold after five years for around $15,000 to smaller farmers who use the trucks for another ten to fifteen years, Maintenance costs average $4,000/year and fuel costs average $12,000/year for each truck.

Wells currently owns and operates three feed trucks, One of his trucks recently passed 150,000 miJes and is approaching its fifth anniversary at Chaparral. Another truck is two years old and the third is three years old, Because cattle often rush the bunks when feed is delivered, it is not feasible to only partially fill a pen on a given trip, Each trip must serve an integer number of pens, Currently, Wells has 38 pens of 260 head each on La ration (two peris per trip) and 56 pens of320 head on Hi ration (I pen per trip),

Milling equipment is expensive and requires considerable maintenance. Although each feed truck is fitted with a feed scale, a large in-ground truck scale is required to weigh incoming and outgoing cattle. Additional buildings are required for administrative tasks, hospital, and equipment repair. Table I shows detailed investment data for equipment items,

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CaseNet® Chaparral Beef

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Labor. A large feedlot operation employs between 12 and 15 people per shift. Labor is one of the largest cost elements in the feedlot operation, and it is difficult to attract and retain enough skilled and hardworking ranch hands. Because regularity in feeding time is important, reliable and consistent help is essential.

Lonnie Mack, the full-time Cattle Manager, supervises and monitors all the activities related to cattle operations. He is responsible for the health of the herd, shipping, and processing of all animals. Lonnie relies on his pen riders to monitor the health and activity of the cattle every day in every pen_ Pen riders are experienced cattlemen who are trained to identify. illnesses and other operational problems as they occur. Identifying and treating sick animals in a timely manner prevents the spread of disease, limits death loss, and reduces the overall stress of the animals. During ration changes or extreme weather changes, cattle will often bloat. Bloat victims will often die if not treated within 24 hours. For this reason, every animal must be viewed each day. Pen riders will also identify ration problems as they occur by observing fecal matter and animal activity.

Table 1 Financial Information for the Ranch

Feeder Operation

Capacity Feedlot Utilization Head per year (range = 32,000 to 50,000) Average In-Weight Desired Finished Weight Avg. Daily Gain Holding Period Net Gain Feed Conversion Factor (Ibs. per Ib of gain) Feed Required Per Head Ration CostfTon Market Steers-selling price per cw!.

Fixed Investment for the Ranch

Inventories Pens and Equipment Water and Equipment Milling Equipment Feed Storage Facilities Feed Trucks Manure Equipment Transportation Equipment Repair Facilities Land Office Scales Total

$17,728,774 810,198 130,824 784,944 140,346 135,000

17,802 36,432 42,228

199,134 52,164 67,068

$ 20,144,914

60,000 69%

41,400 750

1300 2.8 196 550 9.2

5060 $118.21

$74.01

Annual Fixed Costs

Depreciation Interest Property Taxes Insurance Repair/maintenance Management (3) Administrative Salary (4) Part Time Office Help Labor: Drivers (4) Pen riders (5) Mill operators (3) Hospital vet tech. (2) Pen Cleaners (2) Mechanic (1)

Total

head

average

pounds days pounds

pounds

Per Year

$ 268,537 298,287

15,939 13,662 34,155 90,000 80,000 10,800

80,000 100,000 60,000 46,000 36,000 19,000

$1,152,380

© South~Western ~ollege Publishing ISBN 0-538-lJ8964-O Shaun Andrikopoulos, John K. Shank

Variable Costs Per Head Per Year

Feed $ 299.07 $ 12,381,552 Mortality loss (1.5%) 14.43 597,483 Veterinary and Medical Supplies 5.89 243,639 Gas and Oil 1.16 47,817 Eleclricily 2.04 84,249 Natural Gas 1.21 50,094 Telephone .22 9,108 Shipping 13.00 538,200 Other .. 99 40,986

Total $ 338.00 $13,993,128

Profitability Per Year Per Head Per cwt

Revenues $ 39,832,182 $ 962.13 $ 74.01 Purchase Price 23,638,365 570.98 43.92 Variable Costs 13,993,128 338.00 26.00 Fixed Costs 1,152,380 27.84 2.14

--- --Net Profit $ 1,048,309 $ 25.32 $ 1.95

The ranch also employs a full-time vet technician. Although the 'vet tech' is not a Doctor of Veterinary Medicine (DVM), he is trained and experienced in treating most health problems at the feedlot. A consulting veterinarian usually visits feedlots twice monthly to treat difficult cases and to identify or warn of health problems that have regional implications.

Administrative Office. The office is staffed by a full time secretary/ receptionist who is responsible for greeting visitors and answering calls from buyer:s~ sellers, feed suppliers, and whoever else. Wells' receptionist also assists with some computer work.

A full-time personnel manager is responsible for maintaining employment records, health insurance and benefits records, monitoring OSHA requirements, and tracking vacations and shift requirements. The personnel manager also serves as a public relations contact.

A full-time accountant is responsible for general accounting, tracking all feed . costs, rations, animal costs, and receipts. The accountant spends 50% of her time entering and tracking daily feed slips that are provided by each driver. Commercial feedlots track every ration individually. Drivers manually record one ration slip for each truckload of feed and one ration slip for each pen that is fed. The accountant utilizes a part-time assistant to help enter and track all feed slips in the computer.

Fred Wells is responsible for the entire operation. As noted earlier, about 40% and 20% of his time is spent selling and purchasing cattle, respectively. The remainder of his time is consumed making investment and other operational decisions. He also tries to track the feed performance of his cattle every day.

Pen Formation. One major challenge facing the ranch all the time is forming pens of cattle that are of similar age, overall size, and weight. Preferably, the cattle in a pen should also have the same genetic characteristics. The' more uniform the pen, the more efficiently the cattle will convert at the packing plant.

Many operators use "order buyers" to supply them. with animals of similar makeup. Order buyers travel to cow/calf and stocker operations to purchase herds that will be formed into uniform pens of feeder cattle. These buyers also purchase weekly at regional auctions to form groups of similar cattle which are then delivered to feedlms. Cattle coming liirectly from the ranch are the freshest. Animals sold at auction are exposed to more disease and shipping stress, and may come from unknown

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producers. Using an order buyer saves the genem! manager considerable time in forming pens.

Junior's Proposal. After a week of riding pens and feeding cattle, Junior began to miss the challenges of his first-year MBA program. He began to think of better ways for his father to run the business. He thought to himself, 'This place hasn't changed a bjt since I was in high school ten years ago. I just can't believe there isn't a more effective way to run a ranch like this."

After feeding the last pen of steers, washing his feed truck and turning in his ration slips, it was 7:30 in the evening. Fred and Junior hopped in the pickup for a hot two­mile ride home. Junior made Dad a proposition.

Dad, i/youlel me spend the rest of the summer as a consultant on the business is­suesfor the ranch, I'll bel you I can save you $10 a year for every dollar you are paying me. If not, /will owe you the summer wages.

Fred thought for a few seconds) smiled and said) "It's a deal." He was worried because declining cattle prices meant ranchers \vollld hold onto lheir cattle longer. As the national cattle inventory was increasing, buyers would have more purchasing power in the weeks to come. The longer-term result would be fewer cattle put into feedlots which would ultimately reduce supply and begin the next upward cycle in prices. In the short run, he was particularly concerned over what price his next sale of 1500 heifers would bring, so he told Junior, "Let's start now. How can you get me higher prices for the next sale?"

Junior rose to the challenge.

One a/the things we s'llIdied in school this year was'the way many suppliers and customers have set up supply linkages to take advantage of quality improvements, scheduling efficiencies, and reduction of marketing costs and purchasing costs. Basically, these guys enter into agreements 10 act as sole suppliers or cllstomers with a special pricing agreement between the two parties. I'm not sure this con­cept could ever work in ollr situation, but it may be something to look into.

Come on Junior, you know / could never get in bed with lvlonJoN or Excell. Those guys would steal me blind if 1 let 'em. Anyway, 1 wouldn't be able to price shop between packers. EvelJ'one 'wants my cattle and! know that I ccm always do a lil­tie beller if 1 play those guys off against each other.

Yeah, but that's what every feedlot operator thinks, contended Junior. If you really do have better cat/Ie, clon't you think YaH could command a better price, on average, if the packers paid only for what they got?

I'm not sure Ijbllow you, son.

fVell, it seems to me that ifYOll sold your cattle exclusively to tv/onfort, YOll coulcl work aliI an arrangement where you got paid a percentage premium above average spot price If your cattle graded out better than the weekly averages.

Doubtful. The packers already know the price they pay for callie takes into ac­count an 'average' quality oJthe carcass gracle. Paying moreJor a better quality carcass would only increase their costs. Anyway, most of those buyers know a good pen when they see one and are willing to settle Jar a higher price when the quality is there.

Well, couldn't the arrangement stipulate that jar those cattle yOll sold that were below average grade, you wOlild be assessed 1I penallY? YOli knOlv that Ihe

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ISBN 0-538-<18964-0 © South~Western College Publishing

Shaun Andrikopoulos, John K. Shank

grading is objective. Those USDA inspectors don 'tlike the packers mry 1I10re than you do.

Fred paused a moment.

You know, Junior, 1 could save a 101 of lime if 1 didn', have to deal with those damned buyers eve,y day. / could see 'where this arrangement could eliminate the need for those guys to come DIll here and shoot the bull for three hours while we argue about pri~es.

That's right, Dad. Because Monfort would be paying only for what they get, they wouldn't have any uncertainty about the animals they have purchased It's a kind 0[. .. quality control mechanism!

f would love to be able to look into my operation more, ijllSI haven 'f had the time. Although I have just installed a new computer and upgraded my scales, 1 haven't had lime to see how my cattle are really converting. J can 'f even lake a dayoJlto go (0 a presentation on intensive feeding techniq1les. J kno\v that there are better ways to run this business; fjllst don', have time to really look into any of them.

Fred Talks to Monfort "Yes, this is Fred Wells. I'd like to speak to Kenny Monfort." "I'm sorry, Mr. Monfort is out of the office at the moment. May I take a message?" "Sure, tell him that I called and that I would like to visit with him as soon as possible," Fred replied.

Kenny reached Fred that afternoon after two tries on the phone. "Howdy Fred, . what can I help you with?" The two exchanged pleasantries and got down to business.

lvly son has recently returned from business school and has some interesting ideas about how I can ifnpl'ove the business. I realize that you were recently bought Ollt by ConAgra so I'm not sure how much 'discretion Y01l have over these issues, hut I'll give it a whirl.

Well, I'm still the boss here. What do you have? Kenny replied.

Ivly son anel I have discussed the possibility of entering into an exclusive sales agreement with YOll, something they call a 'supplier/buyer' linkage.

Yeah, since ConAgra bought uS alit, I've been reading up on how to improve my quality. This seems to be a recurring theme. Kenny seemed interested. But I'm not sure it could work in this industlY. Everyone has pretty much the same cattle. You know that.

Junior and 1 talked about this. 1 know that ,vhen you buy animals that are over fin­ished or inconsistent, they don't grade as well, and they certainly don't yield as well as consistently finished animals. Suppose that 1 could supply you with consistently fin­ished cattle that yield grade well. You already provide me with the grade results for all of my animals anyway, so I know that it is possible to track my animals through your plant.

Yes, that's correct.

If we could agree on a premium that could be paid for each of my animals that yield grw{v !Y?'!'!r than cnJerage, and a discount Jor each oJmy anim(J/s thaI grade below average, we could get rid of the gues'!'work your buyers go through each time they bid 011 a pen a/my animals.

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SlIre, but lvhat base price would we lise? You know thaI price discovelY in this business is slim at best, Kenny warned.

Well, / haven '( really thought about it, but I'm sure we could lVork it out. Are you interested in exploring this further?

I'd be glad 10. I Jusl don 'I wanl you 10 gel your hopes up. 1'1/ have 10 run Ihis pasl the guys in Omaha, Kenny continued. LeI's gel together tomorrow at seven thirty in the morning over coffee.

Sounds gOO[( 1'1/ meel you al "'Imine's Kitchenfor breakfasl.

See yOH there.

Fred and Kenny met several times to discuss their linkage proposal before Kenny presented it to headqumters. In his presentation, Kenny emphasized that his Selling anq Administrative expenses will be reduced by the agreement. He also emphasized that overall processing costs would be reduced if Wells could, in fact, produce consistent, high quality animals. Surprisingly, headquarters was very positive about the plan and gave Kenny full go ahead to experiment with the linkage.

The Wells-Monfol1 agreement stipUlates that Wells will ship cattle, sight unseen, with one-week notice to Monfort. Monfort, in turn, will pay Wells an average weekly spot rate for his cattle. After the cattle are slaughtered and carcasses graded, Wells will be paid an 8% to 10% premium (or discount) for his cattle, based on how they compare to all oftl~e cattle slaughtered in Monfo~ plants during the same week.

Although Fred was still a little apprehensive about having to tum away buyers from Excel! and IBP who compete with Monfort for his cattie, he· believed that the agreement would have long-term benefits. Fred enjoyed calling the Excell and IBP buyer's offices to inform them that they need no longer call on him.

Fred realized his time savings immediately, Monfort would ultimately pay Wells exactly what his cows were worth. This might be more or less than current prices, depending on who was "winning" the negotiations now. The linkage would only increase overall returns over time if it produced better beef.

The Extension Service Presentation. Fred soon began catching up on the pile of conversion performance reports that had accumulated on his desk. Fred also began to look into some of the latest management practices he had read about. He began to push some ideas at Junior for him to analyze using his high-priced Ivy League ideas. Fred ran down Lonnie in the hospital pens.

Hey Lonnie, do you have a few minuJes to talk to Junior and me about the inten­sivefeeding presentation you went to a couple of weeks ago?

Sure, we can lalk now. I was impressed by Ihe guys Ihal spoke. They had a 101 of interesting feeding techniques to talk about. Lonnie continued, But 1'm just not sure how cost effective these techniques will be in the real world. One researcher showed us how feeding La ration callie twice a day and Hi ration cattle three ttine a day might improve conversion by three to five percent. Blit that ain't much. I've got the data in my notes.

Besides, our trucks hardly ever stop running now and we only feed the cattle once a day. Ifwefed two or three times a day we 1-lIould have to buy more trucks. Be­sides the cost, J'm not ready 10 deal with the labor problems. There's no way thaI afourpercent increase in conversion wOlild offset those costs.

ISBN 0·538-138964·0

What else did they talk abo lit? Junior said.

© South-Western College Publishing Shaun Andrikopoufos, John K. Shank

A few guys have been experimenting Wilh pens of 600 cattle. They call 'em 'Su­perpens.' According /0 these guys, you can build a more ejjicient pen system if you go to larger pens. I can see how it would make it easier on the pen riders to have a better look at !he cattle each day, but il seems that the pens would have to be huge in order/or Ihis system 10 work. At24 inches a[bunk space per head, a pen would have to be 1200 [eetlong.

Lonnie frowned, showing his skepticism of academia.

Think [ cOllld have a look at your notes, Lonnie?

Sure, [ don '/really need 'em. The stllff is prelty /atfelched

Junior discovered that recent research shows that cattle convert better when they are fed close to their natural digestive cycle. La ration cattle (the fIrSt 88 days of feeding) are fed a high roughage (60% roughage 40% protein) diet which becomes more protein rich over time. These cattle digest on a twelve-hour cycle. Hi ration cattle (the last J 12 days of feeding) are fed a 92% protein diet which they digest on an eight-hour cycle.

Cattle, like people, digest more efficiently if they are fed on a regular schedule. The researcher's test site feeds Lo ration cattle twice a day, and Hi ration cattle three times a day. Each feeding is administered within five minutes of the prescribed time each day. Because the researcher feeds more fi'equently, the cattle do not "rush" the pens to feed. As a result they eat at a slower rate and are able to consume more per day than if they eat only once.

Ration adjustments also turn out to be easier with the smaller, more frequent feedings. As a result, the researcher has reduced the overall ration requirement by 1 % because of left-over savings. Also, the intensive feeding schedule has resulted in 4% improved conversion efficiency. Because the animals don't rush the bunks during feeding, it is common to observe 1/3 of the cattle sleeping, 1/3 of the cattle standing, and 1/3 of the cattle coming to the feed bunks.

The "Superpen" Innovation. One large operator (100,000 head capacity), Elvin Bishop, has created 32 "Superpens" that hOllse about 600 cattle each. Because Superpens are larger, they are easier for pen riders to monitor than smaller pen combinations with the same capacity. Pen, riders can spend more time observing cattle in super pens and less time moving between pens. Increased observation time allows the riders to identity up to 50% more bloat cases and respiratory problems than before. This has resulted in a decrease in mortality rates of up to 50% for Bishop's operation.

Superpens have also resulted in reduced administrative costs. Because each driver completes a slip for each pen fed, the total number of slips that need processing is cut in half. Similarly, Bishop, the General Manager, has reduced the amount of time he spends managing individual pens by a similar ratio. Superpens also cut in half the required interactions with cattle buyers.

The primary challenge facing Bishop with his Superpen is to identify 600 similar cattle for each pen. Previously he was able to fill two pens which could differ. For example, one pen could be filled with shorter, lighter Angus cattle and another pen could be formed with larger cross-bred cattle. Because Bishop must form larger uniform pens, he relies on order buyers to supply him with calves of similar weight and genetic and geographic backgrounds.

A UBigll Truck. Bishop also lIses a \;Big" truck to feed his cattle. He claims that he ha6-saved some operation expense 'with the new truck-'System, -but he hasn't had il-'­

chance to look at the long-term benefits of llsing the truck. The "Big" truck has an operating capacity of 810 cu. ft. and costs around $103,000. The 24,000-pound

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capacity trucks operate sim ilarly to the smaller trucks but they require about 25% more fuel.

Fred asked Junior to look into a new "Big" truck for the ranch. Junior wasn't sure it would make economic sense to spend $103,000 on a single truck. He realized that the value of the large truck at the end of five years would not be appreciably more than that of a small track The secondary market for used trucks consisted entirely of small operators who would not be interested in the excess capacity of the «Big" truck.

Fred also asked Junior to investigate the Superpen and Intensive feeding practices to see if they really were cost effective_ Junior had his hands full for the summer as an MBA analyst, but at least it was more interesting than shoveling manure. As the summer progressed, he was often struck by the similarity in the two jobs.

ASSIGNMENT QUESTIONS

1_ Using the information in the accompanying industry note and in the case, layout the economics of the beef value chain from the cow/calf ranch to the supermarket. From this value chain perspective, evaluate the advantages and disadvantages of the. Wells-Monfort linkage_

2. Does a large truck make sense for Wells given his new, enlightened view on man­agement? Is one "Big" truck sufficient to meet the needs of the Chaparral ranch?

3_ If you were Junior Wells and you started your analysis of "Superpens" by just ana­lyzing Chaparral's finish-ration cattie, how would you approach the analysis? Would this innovation make sense if the pens cost him $10,000 each to upgrade?

4. If Wells decides to implement intensive feeding, how much will his costs increase if he feeds his animals with the same frequency as the Researcher? Coupled with a 4% improvement in conversion, what is the net impact on Wells' bottom line? Does it make more sense for Wells to use 4% improvement in conversion to reduce the holding period per cow by 4% or to increase the selling weight by 4%?

5_ Where would you focus your future management efforts if you were Fred Wells?

6_ Assuming that the conversion rates do not change (pounds of feed per pound of weight gain), does it make more sense for Wells to purchase 500 pound animals di­rectly from CowlCalf operators, or 750 pound animals from Stocker operators? The 500-pound animals will finish at 1050_ Assume that both calves will gain weight at the same rate per day and the total ration cost won't change (9.2 ration pounds per pound of weight gain x 500 pounds gained = 5,060 pounds of ration per calf. As­sume that a 500 pound animal costs the feedlot $5.00/cwt more than a 750 pounds animal because the extra 250 pounds is not viewed as equally high quality meat

ISBN 0-538-88964-0

NOTES

© South~Western College Publishing Shaun Andrikopoulos, John K. Shank

___ 11

Tashtego

Should the motor vesse! Toshtego be used as a freight tender between Dar-es­Salaam and Zanzibar in East Africa or as a tapioca ship between Balik Papan and Singapore in the East Indies? Or, is this 100 narrow a view of the management issue involved?

Macedonian Shipping (MS) typically purchased one or two ships each year. In 1963 MS bought only the Tashtego. She was launched in October. The ship was named for the Wampanoag Indian from Martha's Vineyard who was second harpooner on the whaling ship Pequod in Melville's novel, Moby Dick. In contrast to the other 27 vessels of the fleet which were all of about 12,500 tons burden, the Tashtego was a small ship of only 4,500 tons (the burden of a freighter is the weight of freight of standard bulk it can carry). It had been acquired to allow Macedonian Shipping to compete on the tapioca trade between Balik Papan in South Borneo and Singapore. There was essentially unlimited tapioca for export out of Balik Papan, but the harbor channel w.as such that only small vessels like the Tashtego could get in. Tashtego was making 50 round trips a year on this route. The operating cost per dollar of revenue for a small vessel, fully laden, was higher than would be the case for a large ship. But the larger ships were not able to navigate the channel. Operating costs for the two sizes of vessel owned by Macedonian are shown in Exhibit 1.

Less than a year after MS put tile Tashtego into service, the port authority of Balik Papan obtained a grant to deepen the harbor channel. Ships of up to 15,000 tons would be able to use the port after the deepening .project, which was expected to be completed in September or October of 1965. It would then be possible for the larger vessels of the MS line to serve Balik Papan. The greater carrying capacity of the larger ships should, it was thought, more than compensate for the higher total operating costs of such a vessel.· The larger vessels would have to call at Balik Papan at least as frequently as Tashtego in order to fulfill shippers' requirements. If the big ships called lit Balik Papan, they would have to stop twice at Singapore, once before Balik Papan and once after. This was because (I) the tapioca had to be transshipped at Singapore, (2) the large vessels were usually too full of cargo on the eastward run to get the tapioca in as well before calling at Singapore, and (3) the cargo to be moved from Singapore to Balik Papan had to be loaded. Whether the company dedicated one large ship to this route or used different ships as necessary as they passed Singapore was not deemed critical to the analysis.

The round trip between Singapore and Balik Papan by the best navigable route was 960 sea miles. At the normal sailing speed of the larger vessels in these waters-16 knots-they required approximately 2 112 steaming days. This compares with slightly less than 3 112 steaming days for Tashtego.

The larger vessels could carry 6,850 tons of tapioca on each voyage from Balik Papan to Singapore versUS 3,950 tons for Tashtego. It was thought that the bookings of manufactured goods that were currently being taken from Singapore to Balik Papan by Tashtego would be the same for the larger vessels. This quantity was based on demand, not capacity. Tashtego was carrying 3,150 tons of manufactured goods on a typical voyage from Singapore to Balik Papan, at an average revenue of $2.70 per ton.

244

The cun'ent freight rate for tapioca was $5.10 per ron for t.he trip from Balik Paprm to Singapore. There appeared to be a stable or increasing demund for the commodity. While the freight rate might go up in the future, it was reasonnble to assume that it would not go down.

Thc turn uround time (Ule period between the ship's urrivul at a port and departure from it) ut Balik Papan wus relatively slow. Because of the inadequacy of the cmnage facilities, it would take 3 days to turn one of the lurge vessels versus 2 112 days to turn Tashtego. This difference was caused by the greater amount of cargo to be moved in the larger vessels.

Because of the extensive modem facilities at Singapore, all ships of the size being considered could be turned around in 1 day, regardless of the amounts being loaded or discharged.

ALTERNATIVE USE OF TASHTEGO

Peter Georgopoulis, President of Macedonian, felt he needed to find " new use for Tashtego. The best alternative seemed to be using it as a freight tender between Dar-es-Salaam (in East Africa) and the islund of Zanzibar. At present, the large vessels of the line called at both of these ports, incurring port charges as detailed in Exhibit 2. The Macedonian ships used lighters in place of docking in all the ports listed here because it wus less expensive and often quicker for the small umounts of cargo involved. The cargo, which consisted of datcs and ground nuts iTom Dar-es-Salaarn, and coconuts, copra, and special timbers from Zanzibar, was usually carried to the United States. The fi·eight normally collected on each trip at the two ports nmounted to about 1350 tons in Dar­es-Salaam and 2500 tons in Zanzibar. The large vessels were calling 80 times a year at the two ports.

If Tashtego were to be used on this alternative route, it would shuttle the cargo from one of the two ports to the other, so that the large vessel need make only one stop in the area on a given run, thereby saving time and portage dues. The incremental costs which would be incurred by Tashtego at the two ports are summarized in Exhibit 3.

The sailing time between the two ports was very short, and this distance (72 miles) was such that only I day (2 days round trip) was involved no matter which vessel is being used. The higher speed of the larger vessels had no noticcable effect over such a short trip. It was thought that an ovenllJ savings of 3 days per voyage would be attained by the large vessels (one port call (2 clays in either port) and a day of steaming in transit) if Tashtego were us:d on the Zanzibar/Dar-es-Salaam run.

Tashtego

If Tashtego were to be used as a "shuttle," it would be necessary for scheduling purposes to have the larger ships call at the same port each time. Exhibit 4 evaluates which port to eliminate for the large vessels.

Mr. Georgopoulis was anx.ious to arrive at a decision about whether or not to move Tashtego. An

. opportunity had arisen to move the ship from Singapore to Zanzibar with a cargo which would cover the cost of moving the ship. As this was a very unusual cargo, it was not thought likely that a similar opportunity would arise before autumn.

He was anxious to keep all the ships as active as possible. The company had a very good reputation among shippers and had therefore been able to fiJI its ships all the time. In fact, Macedonian was one of very few fully booked shipping lines in the business.

The most recent income statement of the company is shown in Exhibit 5. The year ended December 31, 1963 wus considered a typical year for the company.

QUESTIONS

The issue in this case is very exotic-should the motor vessel Tashtego be used on· the tapiocu run between Singapore and Balik Papan in East Asiu or as a freight tender between Zanzibar and Dar-es-Salaam in East Africa? This decision hinges on a cost analysis as to which option is more profitable. One issue we will discuss in class is what constitutes a "variable" cost when some costs vary per ton, some per day, some per mile, and some per stop. Other issues we will discuss include the importance of defining the alternatives precisely, the concept of profit contribution per unit of capacity, and the role of cost analysis in helping management to ask the right questions.

In order to help you work through this difficult but also valuable case, the following specific questions should be answered in order. These questions help you develop, piece by piece, an overall analysis of the decision. Try to imagine tackling the case with no specific questions as a guide!

I. How much profit contribution can be earned by carrying I ton of tapioca from Balik Papan to Singapore, dock to dock, considering revenue and cargo costs? How much can be earned by carrying 1 ton of general merchandise from Singapore to Balik Papan?

2. Given the contribution/roo figures arrived at in question I, what is the total contribution which cun be

Tashtego

earned on one rollnd trip by Tashtego between Singapore and Balik Papan and return? By one of the large vessels?

3. Independent of the amount and type of cargo carried, what are the incremental trip costs of sending Tashtego on a round trip between Singapore and Balik Papan? One of the large vessels?

4. Considering revenue, trip costs, and cargo costs what is the total contribution per round trip for each of the vessel types? What is the total contribution per year for each of the vessel types?

245

5. What is the overall profit impact jf Tashtego is moved and large vessels are used on the tapioca run? (Hint: Pull your answer to question 4 together with the infOlmation in Exhibits 3 and 4.)

6. What actions should Mr. Georgopoulis take? Why? (Hints: I) "What is Macedonian's average profit contribution per shipping day for 1963? 2) Was buying Tashtego to use as a tapioca ship a good investment decision, based on infonnation available at that time?) E

EXHIBIT I Annual Operating Costs or Vessels

Item Payroll Depreciation (straight line, 15 yr. life) Repairs . Stores and Provisions Insurance Miscellaneous

Total Annual Cost*

On average, there were 345 operating days in a year, so the cost per operating day was

In addition, bunkering costs (fuel costs) were incurred amounting to

Costs Typical for Size of Vessel . 4,500 Tons 12,500 Tons

$143,594 $210,877 222,956 363,226 40,000 47,500 32,657 39,283 36,030 46,750 12,975 22.525

$488212 S1:lli163

$1,415 $2,116

$0.73 per mile $1.27 per mile

*In general, these costs were committed one year at a time if a vessel was in use. The costs did not vary depending on cargo or route.

TyPically, 2/3 of the cost of a ship could be financed over its depreciable life at rates averaging 5% in 1963.

246 Tashtego

EXHIBIT 2 Cost of Port calls

Cost Item Varies with: Unit Balik Papan Siogapore Zanzibar Dar-es Salaam

TriQ Costs Portage dues Tonnage of burden $/day in port! 0.14 0.20 0.13 0.31

ton burden

Lighthouse Per trip $/visit 73.0 126.0 62.0

Special

Assessment Per stop $/visit __ a

Cargo Costs

Lighterageb Freight moved $ ton of freight 0.25 0.16 0.14 0.15 moved

Stevedoring freight moved $/ton of freight 0.56 0.32 0.32 0.32 moved

Cranage Freight moved $/ton of freight C 0.14 0.13 0.13

a All ships exceeding 8,000 tons burden were to be assessed $2,000 for each port call (in addition to portage dues). This assessment was iotended to contribute to the iovestrnent in and maiotenance of the new deep channel that these ships required.

b Lighterage expense is the cost of having small barges called "lighters" come alongside the vessel anchored in the harbor to facilit~te loading and unloading of cargo. C There is no cranage charge at Balik Papan because the freight is manhandled. This considerably increases the charge for stevedoring relative to other ports.

EXHIBIT 3 Costs of Using the Tashtego in East Africa

Dar-es-Salaam Zanzibar Total 1. Trip Costs

Portage Lighthouse

$1.170b $1,395" 62

$1,457 + $1,170 $ 2,627 Sea Bunkering (.73/mile x 144 mile round trip) =.

Times 69 tripsc

2. Additional Cargo Costs on the Dar-es-Salaam Cargod

Total tons/year = (1 ,350/trip x 80 trips) = 108,000 tons Unloading costs@Zanzibar(.14.+.32+ .13) = .59 11.18 x 108K tons = Reloading costs @ Zanzibar (.14 + .32 + .13) = .59 1

a 4,500 tons x .3l1day/ton x I day = $1,395

b 4,500 tons x .13/day/ton x 2 days = $1,170

.!ill. Total 2,732/trip

$188,508/year

$ I 27A40/year

Total = $315,948/year

C 345 days (from Exhibit 1)15 days per trip (2 in Zanzibar + 2 at sea + I in Dar-es-Salaam). It is assumed in the case that the decline in customer service in Dar-es-Salaam involved in cutting back from 80 pickups per year to 69 is not a binding consideration.

d The same tonnage must be loaded at Dar-es-Salaam per year as now, so the only additional charges are for unloading this Dar-es-Salaam cargo in Zanzibar and for reloading it in Zanzibar onto a large vessel.

Tashtego 247

EXHIBIT 4 Why the Large Vessels Should Eliminate the Stop at Dar-es-Salaam

Inspection of Exhibit 2 shows that Zanzibar has far cheaper portage dues than Dar-es-Salaam, is at least as cheap in all other cost categories, and has no lighthouse charge. Therefore, at first glance it appears that the Dar-es-Salaam port call should be eliminated for the large vessels. We 'must be careful, however, because cargo at the eliminated port will have to be doubled handled. If Dar-es-Salaam generates more cargo, lolal cost might be lower if Zanzibar were eliminated. But Zanzibar generates more cargo (2,500 tons per call vs. 1,350 tons). Therefore, without detailed calculation, we can conclude that the large vessels should call at Zanzibar.

Cost savings by having large vessels avoid Oar-es Salaam:

Portage dues (2 day port call) Lighthouse fee

Bunkerage

Total per tripC

Times 80 trips

a 12,500 tons x $.3l1day/ton x 2 days = $7,750. b $1.27/mile x 72 miles = $91

$7,750a

62 7,812

2lb

$7,903

$632,240 per year

C No stevedoring, lighterage or cranage wiiI .be saved as the cargo will still have to be loaded onto a ship at Dar-es-Salaam eventually. .

EXHIBIT 5 MACEDONIAN SHIPPING COMPANY

Income Statement for the Year Ended December 31,1963

Voyage Revenues for the Year Voyage Expenses'

Gross Margin

Shore Support and Administrative Expenses Net Income before Taxes

Income Tax Expense (52%) Net Income

*Ship costs, trip costs, and cargo costs.

$49,661,000 33.480,000 16,181,000

10,234,000 5,947,000

3,088,000 $2859.000

....... DARDEN i/iliii UV0225 BUSINESS PUBLISHING

UNIVERSITY if VIRGINIA

MAVERICK LODGING

In early January 2000, Cindy Baum was reviewing the 1999 balanced scorecard results for Maverick Lodging. As the vice president of Asset Management, Baum had developed and implemented the balanced scorecard throughout 1998. Thus, 1999 represented the first full year of results using the balanced scorecard approach. She was anxious to see if the scorecard she had created was accomplishing its primary objective of aligning the company's strategy, structure, measurements, and incentives.

Developing a balanced scorecard had been a considerable challenge, because of the complicated nature of the hotel industry. Baum's employer, Maverick Lodging, managed hotels on behalf of third-paliy owners who had franchise agreements with the Marriott Corporation. Maverick Lodging concentrated on managing three specific types of Marriott properties: Fairfield Inns, Courtyards by' Marriott, and Marriott Residence Inns. Fairfield Inns and Courtyards by Marriott offered the typical variety of hotel rooms, whereas Residence Inns offered "suite arrangements" that included a kitchen, sitting room, and one or two bedrooms. The Courtyards typically had a restaurant, whereas the Fairfield Inns and Residence Inns did not. Instead, they had a gatehouse area that served complimentary breakfast.

Because third-party owners had many choices among hotel-management companies, including the Marriott Corporation, Maverick Lodging believed that adopting a balanced scorecard framework might help differentiate its services. In addition, Baum believed that a good balanced scorecard would be particularly useful to her because, as the vice president of Asset Management, she was the principal liaison between the hotel owners and Maverick Lodging. Therefore, she had primary responsibility for ensuring that the contract terms and both parties' objectives were met. Maverick Lodging was one of the earliest hotel-management companies to implement a balanced scorecard management system.

This case was prepared by Karen Whitney (MBA 2001) under the supervision of Professor E. Richard Brownlee II and Assistant Professor Luann J. Lynch. It was, written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. The case is based on publicly available information. The author would like to thank Greg Denton, former director of Asset Management of White Lodging, for his useful insights during the preparation of this case. Copyright © 2002 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail 10

sales@dardenpublishing.com. No pari of this publication may be reproduced, slored in a reJrieval sysJem, used in a spreadsheet, or transmitted in any form or by any means-eiecJronic, mechanical, pholocopying, recording, or othenvise-wiJholil tJJe permission of the Darden School Foundation. --

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As Baum reviewed the results for 1999 (see Exhibit 7), she wanted to understand how the business had performed, assess the overall effectiveness of her balanced scorecard, and look for ways in which it might be improved. She was to report her findings and recommendations to Robert Sandlin, Maverick Lodging's president and CEO, the following week.

Baum felt that her meeting with Robert Sandlin would decide the fate of her career with the company. Maverick Lodging had brought Baum in to be a change agent, including the development and implementation of the balanced scorecard. This first year was crucial for the success of the scorecard and her role in the organization. Successful results from the balanced scorecard could help Maverick Lodging attract more hotels to manage, which would increase Baum's responsibilities. In addition, the hotel managers were counting on the scorecard to work properly, as it was their performance assessment and compensation would be affected by the results. For instance, although the hotel managers had some influence over their hotel rates, prices were largely determined by local market conditions and the market segment being served.

Hotel Industry

The hotel industry was characterized by complexity and competition, and both of these . features influenced Ballin's decision to join Maverick Lodging after she completed her joint

master's degree in Business and Hotel Management. One of her first assignments was to lead the development and implementation of a balanced scorecard management system. Baum felt that implementing a balanced scorecard in a hotel-management company was particularly challenging owing to the multiple parties involved in the hotel industry. Incorporating the perspectives and balancing the various economic benefits of each of the three parties (see Table A) would be necessary in order for the balanced scorecard approach to be successful.

Table A: Structure of the Hotel Iud us try Party Name Description Economic Benefits Franchiser Marriott Licenses name and concept to Receives from franchisee/owner an

Corporation franchisee/owner. initial franchise fee and royalties based on a specified percentage of revenues.

Franchisee/ Various third Enters into a contract with the Retains all the net profit from the Owner parties franchiser and actually owns hotel.

the hotel. Has the responsibility for capital expenditures and for operating the hotel. Frequently hires a hotel-management company.

Manager Maverick Manages (operates) the hotel Receives from the franchisee/owner a Lodging in compliance with base management fee and an incentive

franchiser's policies and under management fee based on a percentage the direction and supervision of house profit. ("Hollse profit" is a of the franchisee/owner. common hotel term for the hotel's net

profit.)

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Maverick Lodging

At the end of 1999, Maverick Lodging managed 38 hotels with total revenues of $140 million. The hotels ranged in size from 50 rooms to 347 rooms, with the majority ranging

. between 75 and 140 rooms. The hotels were primarily located in and around relatively large cities in the states of Florida, Illinois, Indiana, and Texas. In comparison with Marriott International, Maverick was quite small. At the end of 1999, Marriott International owned, managed, or franchised 1,880 hotels with 355,900 rooms and had plans to double the number of rooms over the next five years. The company's 2001 target was to manage 65 properties with $225 million in sales. Maverick Lodging had two types of stated objectives: (1) objectives concerning Maverick Lodging and (2) objectives concerning each managed hotel.

Objectives cOIlccl'IIing Maverick Lodging

I. 15% annual compound growth in managed revenues.

2. $300 million in managed revenues by 2004.

3. Achieve annual budgets.

4. Deliver a 15% ROI to franchisees/owners.

5. Retain management employees by achieving less than 20% turnover.

6. Retain 100% offranchisees/owners.

Objectives concel'lling each managed hotel'

1. Exceed brand average yield. (Yield was the ratio of the hotel's revenue per available room [RevPAR] to its local competitors' revenue per available room. RevPAR was the hotel's roon1 revenue divided by the number of available rooms. Brand average yield was the average yield for all Marriott hotels of a comparable brand [e.g., Courtyard by Marriott].).

2. Grow RevPAR at a specified rate greater than local competitors (i.e., grow yield at a specified rate).

3. Exceed the profitability levels of Marriott-branded hotels owned and managed by Marriott.

4. Be in the top 20% of brand in guest-satisfaction scores.

5. Retain nonmanagement employees (i.e., associates) by achieving less than 60% turnover.

! The external information relating to specific hotel perfonnance was collected on a monthly basis from two sources. Information regarding local competitor performance was purchased from an independent data clearinghouse. Information regarding Marriott-branded hotels (e.g., Courtyard by Marriott, Fairfield Inn, Marriott Residence Inn) was provided by Man'jott Corporation and, except for information regarding profitability, included both'Marriott-managed and -franchised hotels. Profitability information pertained only to Marriott-managed hotels.

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At the time the balanced scorecard was developed, the typical hotel managed by Maverick Lodging was four years old. In general, properties older than five years experienced a decline in guest-satisfaction scores owing to their overall condition and appearance. Robert Sandlin recognized this undesirable tendency and felt that the balanced scorecard might help remedy the situation.

Maverick's organizational structure (see Table B) added another level of complexity to the balanced scorecard implementation. The balanced scorecard was implemented at the hotel level, and was used as a management-control/performance measurement system for each hotel's general manager, who was typically 25 to 35 years old with a college degree but little management experience. As a result, Baum felt that the balanced scorecard needed to be comprehensive but not overly complex.

Table B: Maverick Lodging's Organizational Structure

VI', Finance VI', M:lr!t~tin,'!

Rollert Sandlin Presiuen' and CEO

VI', Operations VI', M:linlcl\llllCC Cindy Dnum VP, Asset MUIl!lgtrllcni

~===:;====='-'=~~~~=: Regional l'Ilrmager 1/1 Regional M:mnger 1/3

Designing Maverick's Balanced Scorecard

Baum involved the four other vice presidents and the three regional managers in the balanced scorecard design process. Not surprisingly, thcre was considerable disagreement about what the balanced scorecard should look like. The entire team finally agreed to create a scorecard with the following attributes:

1. It tracks financial performance.

2. It tracks nonfinancial measures that are important for long-term growth and value creation.

3. It communicates franchisees'/owners' objectives for growth, profitability, and physical maintenance.

4. It is understandable and acceptable to hotel general managers, and it provides them with useful and relevant information.

5. It is understandable, useful, and relevant to Maverick Lodging's management.

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Exhibit 1 illustrates how Maverick's nonfinancial and financial measures were linked in achieving the company's objectives. Exhibit 2 details the actual balanced scorecard.

Balanced scorecard as a performance measurement system

Prior to the introduction ofthe balanced scorecard, the regional managers had a great deal of discretion in determining the amount of each hotel manager's bonus. The average bonus generally ranged between 20% and 40% of the hotel manager's $40,000-$50,000 salary. The bonus depended on the size of the bonus pool, hotel profitability, and the regional manager's assessment of the hotel manager's overall performance. Consequently, most hotel managers felt that their bonuses were somewhat arbitrary. Nevertheless, they paid close attention to whatever fhey believed their regional managers deemed important.

In order to rate each hotel manager's performance through the use of the balanced scorecard, Maverick implemented a numerical point system and five-color rating scheme (see Table C), with concrete targets (see Exhibit 3) for each scorecard measure.

Table C: Point System and Color Rating Scheme Performance Color Ranking Points

Superior Platinum 10. Above Expectations Gold 7.5 At Expectations Green 5 Below Expectations Yellow 2.5 Unacceptable Red 0

In determining a hotel manager's bonus, each measure on the balanced scorecard was assigned a color ranking based on performance relative to the target. This color ranking was translated into a point score based on a predetermined scale from 0 to 10 (see Table C). Then, an overall point score for the hotel manager was derived by calculating a weighted average score using the point scores for the five measures. Each measure was weighted 20%. This overall point score was then translated into a performance factor (see Table D).

Table D: Overall Point Score and Performance Factor Weighted Average Performance

Performance Color Ranking Overall Point Score Factor Superior Platinum 9.0-10.0 200% Above Expectations Gold 7.5-8.9 150% At Expectations Green 5.0-7.4 100% Below Expectations Yellow 2.5-4.9 50% Unacceptable Red 0-2.4 0%

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The performance factor was multiplied by 40% of the hotel manager's salary to determine the bonus. Thus, each hotel manager would receive a bonus ranging from 0% to 80% of salary. The corporate executives and the regional managers were not compensated based on the balanced scorecard. The scorecard was initially devised to be applicable only at the hotel's general-manager level.

Balanced scorecard design

Baum realized that the measures and targets selected for the scorecard (Exhibits 2 and 3), plus its rollout, would affect its ultimate success or failure. She knew there were many possible measures from which to choose, but that those selected must be consistent with corporate objectives. In addition, she wanted to make sure that the measures (1) supported Maverick's strategy and structure, (2) could be understood and used by the hotel managers, and (3) could be controlled or reasonably influenced by the hotel managers.

Financial-top-line yield: The objectives for this measure were for the hotel to exceed brand average yield and to grow revenue per available room at a specified rate greater than local competitors. The key driver in this metric was the hotel's yield, which was defined as the hotel's revenue per available room relative to the local competitors' revenue per available room. (Revenue per available room [Rev PAR] was a standard revenue measure in the hotel industry. RevPAR = [# of rooms sold x rate per room]/ [# of available hotel rooms x # of clays in period].)

As seen in Exhibit 3, morc aggressive targets were applied to hotels that werc underperforming brand averages in an effort to drive improved performance at those hotels.

Financial-controllable projit relative to jiexible budget (jiowthrough jiexible budget): The objectives for this measure were to (I) achieve budget targets, (2) obtain superior financial management of hotels, (3) outperform brand average profitability, and (4) deliver high investment returns to owners. Because the f1owthrough model (see Exhibit 4) entailed the use of a flexible budget, it considered only the costs and expenses that could be influenced or controlled by hotel managers and simultaneously adjusted expected performance to account for variances in top-line room-revenue achievement. The hotel's owner and Maverick Lodging's top management worked together in establishing the annual budgets. The hotel managers had limited influence on setting their budgets.

The f1owthrough flexible budget allowed hotel owners and managers to concentrate on costs and expenses that were under the hotel manager's influence or control. As seen in Exhibit 3, more aggressive performance thresholds were applied to hotels that were underperforming expected profitability levels to encourage improved performance at those hotels. .

Customer-guest-sati;,jaction survey: The objectives for this measure were to ensure (I) the most satisfied guests across the brand, and (2) internal consistency (no properly scoring below brand average guest satisfaction). Maverick Lodging executives knew that guest scores correlated with investment returns; thus, they reinforced the desire for high guest-satisfaction

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scores. As shown in Exhibit 5, the guest-satisfaction survey was quite comprehensive and detailed. The balanced scorecard, however, incorporated only the overall score as shown in the first line of survey question five. .

Internal business-process audit: The objective of the consolidated process audit (see Exhibit 6) was to ensure that hotel management addressed "the basics" of running a property. The audit was conducted by a manager of Internal Audit and had a maximum possible score of 100 points.

Learning and growth-turnover of associates: The learning and growth section was intended to identifY initiatives needed to provide the infrastructure for the organization's future growth. The objective was to ensure that turnover of associates was minimized, as hotels with lower turnover generally performed better.

Communication of the balanced scorecard: Baum felt that the communication associated with the implementation of the balanced scorecard had been successful. Because the regional managers were part of the design and implementation team, they understood the scorecard and supported its measures ancl targets. In addition, throughout the design process, the regional managers had communicated with the hotel managers regarding the development of the scorecard and how it affected them.

Baum explained the balanced scorecard to all the hotel managers at the company's annual retreat in June 1998. Shc also gave them a report showing how their hotel would have performed in 1997 and what their approximate bonus would have been had the scorecard been used the previous year. Thus, the hotel managers had an expectation of what their bonus would be if they had a similar year of performance. None of the measures on the balanced scorecard was completely new to the hotel managers, but the balanced scorecard formalized how their bonuses would be determined and how management would be reviewing their results. The balanced scorecard, with its linked measures, was intended to help the hotel managers understand better what they needed to concentrate on to achieve strong performance results at their hotels. Jane Ellmann, general manager of the Courtyard Hotel in Bloomington, Indiana, stated: "Our balanced scorecard provides us with tremendous focus. It lets our entire leadership team know where we are going, and our priorities guide us on how to get there."

Conclusion

Baum reviewed the 1999 results (see Exhibit 7) and began to assess the major conclusions based on the scorecard data. She thought back to when she developed the balanced scorecard and remembered the discussions she had with the design team regarding its desire to balance substance and simplicity. The vice president of operations had been adamant about the scorecard's being understandable and useful to the hotel managers.

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Initially, Baum was pleased that the major issues of balanced scorecard design and implementation had been anticipated. She had not, however, anticipated the need for hotel managers to have the scorecard modified for individual circumstances. For example, the general manager of the Fairfield Inn in Orlando, Florida, felt that certain aspects of the balanced scorecard did not apply to his hotel because his room -rates were around $150 a night, which was extremely high for a Fairfield Inn but in line with room rates in Orlando. Thus, the guest­satisfaction results from his hotel were low because guests did not feel they received $150 worth of value. Baum was happy that the system was flexible enough that it could be modified on a hotel-by-hotel basis for special situations like this one. Nevertheless, she planned to make sure that these exceptions did not become the rule.

In preparation for her meeting with the CEO, she focllsed her analysis on four impot"tant aspects:

J. What happened in J 999? Was it a good year for the company?

2. What exactly is the company's value-added proposition? Just what competitive advantage is the company trying to build, and does the balanced scorecard system and its related bonus plan SUPPDlt that objective?

3. Is· the f1owthrough flexible ·budget a useful management tool? Is it too complex and confusing? Is it being used properly?

4. What changes, if any, should be made to the balanced scorecard?

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Exhibit I

Relationship of Nonfinancial and Financial Measures

Financial Perspective

Financial Success 10- -

Cnstomer Perspective

-Guest satisfaction

. Internal Business Perspective

-Compliance with standards

Learning and Growth Perspective

-Attracting & retaining top employees

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Exhibit 2

Balanced Scorecard Measures

l'erspective Indicator Performance Measure Tllrget Financial Top-line yield Yield = See Exhibit 3

Hotel's RevPAR Local competitors' average RevPAR

Where RevPAR = Total room revenue

(Room Rate x # of rooms sold) # ofavailable rooms for period (this is # of rooms

in the hotel less rooms out-of-service)

Financial Controllable A flexible budget that reforecasts profitability See Exhibit 3 profit relative based on actual top-line achievement (see Exhibit to flexible 4) budget (f1owthrough • Breaks costs and expenses into two flexible budget) components: controllable and

uncontrollable

• Variable controllable costs.and expenses are reforecast basecl on the appropriate driver

• Fixed controllable costs and expenses are not reforecast

• Uncontrollable costs and expenses are not reforecast

Customer Guest- Overall score from a guest-satisfaction survey (see See Exhibit 3 satisfaction Exhibit 5) survey

Internal Process audit Score from a comprehensive process audit (see See Exhibit 3 Business Exhibit 6) conducted by an internal-audit manager

Learning and Turnover of Associate turnover = See Exhibit 3 Growth associates it of bote I associates ~YIJO left dming ¥ear

(nonmanage- Average # of associates ment employees)

-11- UV0225

Exhibit 3

Balanced Scorecard Targets

I Color Ranking_ --Metric Platinum Gold Green Yellow Red

~.line yield-2 classifications of hotel jJcrformance: (a) Top-line yield above brand 6% increase in yield 40/0 increase in 0.1 % increase in 2.5% decline in > 2.5% decline in aven.ge l or 11 0% of brand yield or 105% of yield or 100% of yield yield

average yield brand average yield brand average yield (b) Top-line yield below brand 12% increase in yield 8% increase in 4% increase in 1 .5% increase in <1.5% increase in average] yield yield yield yield Flowthrough-flexible-budget ratings-3 classifications of hotel performance: (a) Low performers (house profit 106.0% of flexible 104.0% of flexible 102.0% of flexible 99.0% of flexible <99.0% of flexible under 90% of budget), budget controllable budget controllable budget controllable budget controllable budget controllable

profit profit profit profit profit (b) 8ase performers (house profit 104.0% of flexible 102.0% of flexible . 99.0% of flexible 97.5% of flexible <97.5% of flexible at 90-1 05% of budget)' budget controllable budget controllable budget controllable budget controll'lble budget controllable

_profit -

]l1"ofit profit _profit profit (c) High performers (house profit 102.0% of flexible 100.0% of flexible 97.5% of flexible 95.0% of flexible <95.0% offlexible > 105% of budget)' budget controllable budget controllable budget controllable budget controllable budget controllable

profit profit profit profit profit Customer satisfactiou Guest-satisfaction score Increase by 80% or Increase by 60% or Increase by 40% or Increase by 20% or Increase by <20%

top 10% of brand top 20% of brand top 30% of brand top 40% of brand or below top 40% of brand

Comprehensive process audit

Inteillal-process-audit Score At least 97.5 At least 95 At least 92.5 At least 90 Below 90

Employee retention Ann'Jar associate turnover 30% or below or 40% or below or J 50% or below or ~,O% or below or J >60% or

- -_._-- reduce b)' 75% reduce by 50% ._ .J:€'du~ bl' 40~ reduce l:>Y 30% _ ... reduce by <30%

IThe hotel's yield is compared with the brand average yield, which determines whether the hotel's performance is assessed in classification a or b. ~The hotel's actual house profitlbudgeted house profit detem1ines whether the hotel's perfonnance is assessed in classification a, b, or c, See Exhibit 4 for the calculation of

house profit.

Rooms available

Rooms occupied

Average rate

Revcnuc

Room

Food

Beveragc

Phone

Othcr

Total reVl!nue

Controllable expcnscs:

Cost of goods sold

Phone

Phone equipment

Other

Tolal cost of goods sold

P:lyroll

Housekeeping

Laundry

Front desk

Administration

Sales

ivlaintcnance

Other

1999 Budget

72,270

57,809

82.79

4,786,251

204,132

34,135

193,253

92,312

5,310,083

28,171

15,262

207,334

250,767

310,981

35,931

81,700

57,415

18,016

54,857

80,970

-12-

Exhibit 4

Flowthrough Flexible Budget for Courtyard

Rcforecast Target

72,270

57,994

86.98

5,044,032

204,785

34,244

193,871

92,607

5,569,540

23,027

15,262

252,879

291.168

311,976

35,988

81,700

57,415

18,016

54,857

80,970

1999 Actual

72,270

57,994

86.98

5,044,032

266,507

29,319

157,963

107,371

5,605.192

12,179

7,840

260,127

280,146

300,677

38,038

81,549

62,510

15,359

50,358

89,741

Drivers

$86.98 per room occupied

$3.53 per 1'00111 occupied

$0.59 per room occupied

$3.34 per room occupied

$1.60 per room occupied

14.58% of actual phone revenue

Fixed

62.72% oj acllla! food, beverage and other revenue

$5.38 per room occl/pied

$.62 per room occupied up to budgeted rooms; $.31 per room occupied over budgeted rooms

$1.41 per room occupied up to budgeted rooms

Fixed

Fixed

$27,429 plus S.47 per room occupied tip to budgeted rooms

34.0% of food & beverage revenue lip to budgeted rooms

UV0225

1999 Budget

Mgmt (slIlary) 186,223

Employee relations 17,113

Tota! payroll 843,206

Other controllable expenses

Linen 31,217

Guest supplies 47,322

Cleaning expense 29,911

Rqoms. other 61,348

Postag.e 6,500

Office supplies 13,832

AC:ministration phone 12,688

Tr.l\'cI 10,306

Cash over/short

Ilad debt 5,310

Administration, other 23,516

Advertising 14,560

Main sllpplies 6,110

Main. trash, grounds 19,535

M -tintenance 66,326

Utilities 183,573

He·usc charges, other 33,124

TOled other expenses 565,178

Total control/able e.xpenses 1,659,151

Controllable profit 3,650,932

Actual \'5. flexible budget controllable profit

Unc'onlrollable expenses 1,060,261

HOllse profit 2,590,671

i\ct-ual "s. budget house profit , ,

-13-

Exhibit 4 (continued)

Reforccast Taigct 1999 Actual

186,223 174,624

17,949 25,790

845,095 838,646

31,317 29,947

47,473 53,975

30,007 30,966

61,348 71,629

6,500 5,477

13,832 11,676

12,688 12,975

10,306 13,841

(806)

5,570 1,998

23,591 31,357

14,560 11,743

6,110 10,548

19,535 18,231

66.326 70,330

183,867 J 76,824

33,124 32,673

566,154 583,384

1,702,416 1,702,176 3,867,124 3,903,016

100,93%

J, 127,929

2,775,087 107.12 %

Drivers

Fixed

0.32% or total revenue

$0.54 per room occupied

$0.82 per room occupied

SO.52 per roOI11 oCClipied

Fixed

Fixed

Fixed

Fixed

Fixed

0.0% of total revenue

0.1% of total revenue

$0.41 per room occl/pied

Fixed

Fixed

Fixed

Fixed

$9 J, 787 pIllS $1.59 per room occupied

Fixed

Actual controllahle profit! reforecast controllable profit

Given

Controllable profit - uncontrollable expenses Actual house prOfit/budget house profit

UV0225

-14- UV0225

Exhibit 5

Guest-Satisfaction Survey for Residence Inn

Please Indicate your answers with an @ in the boxes or on the lines provided.

1. What one hotel or motel chain have you stayed at most often In the past year; while traveling on b.uslness? (Please select one hotel chain only.)

courtyard by Marriott .•• 0 Marriott Hotels. .•••......•.. 0 Hampton"Inn ." ........... 0 Residence Inn .......•...... 0 Holiday Inn ................. 0 other (please specify below) 0

2. Was this your first visit ever to any Residence Inn?

Yes ............ 0 No ............. 0

3. On your next trip to this area, how likely will you be to stay In this ~esldence Inn again? Would you say y6u:

Deffnitely Will ..... , ..... .

Probably Will ............ . BJ Skip to Q.5

l<1ay or Nay Not " ....... .

probably WI!! Not........ 0 ] O

Continue beflnltely Will Not •.••••

4. Whydo you.say YOU pr9bably or.deflnltely Will not ·-,tavot thls'R~rd~rrce1l'ilnlgQ1nr-~'-"--'- --_.-

(Please cheeR alrthat apply.)

Po-or- clearillness/upkeep .................................. .

H-ritel' In' ~oOr physIcal condlHon .................. .', .... .

Problems. with suite features/amenities ............. .

Unrrlendly/unresponslve/poor service •.••.••••..••..•

Reservation problem/mistake .......................... :.

Noise ............................................................ .

o '0 o o o tJ

Price ............................................... "............. 0 location/other hotels more convenient ..•••••.•.•..•. 0 layout/configuration or suite............................. 0

... ------ --- ------5. Please rate this Residence Inn on each of the features listed below, using a

scale of 1-10, where·l0 Is "excellent" and 1 Is "poor". (if not applicable,

leave blank.)

Excellent Poor 10 9 8 7 6 5 4 3 2 1

Reslde~ce Inn hotel overall............. 0 0 0 0 0 0 0 0 0 0 overall servlee .............. "',,............. 0 0 0 0 0 0 0 0 0 0 Overall value 'or the money.............. 0 0 0 0 0 0 0 0 0 0 overall'malntenance and upkeep ....... 0 0 0 0 0 0 0 0 0 0 Prlee .............................................. 0 0 0 0 0 0 0 0 0 O' Speed/effidency of check-In ............ .. 0000000000

0000000000 speed/~rnclenr::y of check-out ........... .

Ease of.maklng reservation ............... 0 0 0 0 0 0 0 0 0 0 SUite r~servatlon In order at check-In. 0 0 0 0 0 0 0 0 0 0

-suite quality .................................... 0 0 0 0 0 0 0 0 0 0 -Com'ortable place to stay................. 0 0 .0 0 0 0 0 0 0 0 Frlehdll(less of'tarL......................... 0 0 0 0 0 0 0 0 0 0 .Attentiveness of starf ....................... 0 0 0 0 0 0 0 0 0 0 Responsiveness to special requests.... O' 0 0 0 0 0 0 O' 0 0(' Friendliness oHront Desk staff .......... 0 0 0 0 0 0 0 0 0 r '.

.l'J]ysl(;.LgQn®!9JLofJll~.b!lt~L,,,."~~ .. Q ill n Lr=1 In I n In -.0_ - L ... , PhySical condition of the suite ........... 0 0 0'0 0 0 0 0 0 0 ~teafl!Jn:ess or suite upqn entering •• ," 000000000 0

,Oeanlln'ess and upkeep of SUIte

dUrl~g stay, .................. · .. · .... ·;··,·

W~.eJ.;end hou~ekeeplng .................... .

Suite odor .• : ................................. ..

Suite lighting ............ " ... :" ...... " ..... ,

AblUty to work In suite .................... .

Feeling of safety ,,,.,, .... , ......... ,, ........

Overall breakfast ... " ....................... .

Breakfast start attenUveness ............ . Lack of services (e.g' l restalirant) ...................... 0 Prefer another hotel In this area ........................ 0 Breakfast staff friendliness ............... ..

.::' •. ' 1. :,.,.. ' • .:. .":'~T>' '~c _ - • " • _.. ' . _. < ,..,-, , ...... ,., -, 'Varlety of food at breakfast

0000000000 0000000000 0000000000 0000000000 0000000000 0000000000 0000000000 0000000000 0000000000 0000000000 0000000000 0000000000

Not,retUrnlng, to. _thl~.a~~-'~.'-,.;;.:;; •• ~ ... ;. .•• • .. ·,; .... •• •• '·;·~ 'L::.r~·':!~::!':'·· -',,\ - ............. ..

O"e"-(' se" . 'city.' 'b ,'-":-;\ j ':. < - D-·.'-~;" ;~ '~F~.9~ quality at bre,akfast ................. .

.... ,1 •• p~ spe "eow.l;··;~ .. ~'I'~· .. ;;· .. ,,· .... .-.. ';· <_:;,~/ ~;-, ~ . .: ,Wee'kday hospitality hour ............ " .. ..

- I 5- . UV0225

Exhibit 5 (continued)

OnlYifnswer the roJ/owlng question /fyou'Ve been to tho .~ ~ ',.' -:J.O. area mOfl!than once In the p8St year. Otherwise, skip to'~ JAy (,: Q.7. _ ", .. ,f ".'

Overell/, would you say your stay at this Residence fnn:

Exceeded your ex~ctatlon" .................... 0 6. Please think about this Residence Inn In comparison to other"

hotels In the area, Is this Residence Inn better, the sameT or worse on the followIng features?

Better Same Worse Hotel overall ... _ .••. _ ..•.. " .... _ ..•. _ .......... D D D VaJu~ .... , .................. , ........•.. , ..•.•....• D D D LoeaUon .•••.••.•.••.•••••.••..•.•..•..•.•..•• _ •.. D D D OvI!nJ" sel"lf<:e .......... " ..................... D D D Physical COndltlon Of ttle hotel ..... , ...... 0 D D PhysJCilI condition of t~ suite •.••••.••••. D D D

7. Old you experience any hotel relafed problems during your stay?

Yes ............. D Continue

No ............. , D SkIp /0 Q.9

8. If you experienced problems, please indicate below what the problems were and how they were resolved.

ExporlcJlC.(!d Rcrotved, problQ~n. but

R.8801'o'lJd hullook Nol did nollopolt ptompUy 100 long rasolwd 10 staff

(Uthroom deanHne$:lO .............. D D D D Bathroom supplies ..... , ............ D D D D &ddJng dCiI(llin<=ss ................ D D D D BUlinu ................................... D D D D Broken it(!~ ......................... D D D D carpet cleanl1ness .................. D D D D Heat/aIr-conditionIng .............. D D D D Hot tl.Jb/pool/sPllrts; courtj

I;!xercf6tt room .................... D D D D -pests ................... , ..... D D D D Kltch~r appliances .................. D D D D Kltch6\ deanilness .. " ............. D D D D Ught bulb l1Ot'worl£lf10 ............ D d D D Message not delivered!

Incorrea: ............................ D D D D No wa~r/hot water ................. D D D D Noise ....................... , ............ D D D D PlumbIng ............................... D D D D Reservations ..................... , .... D D D D SlJIb! deanllness ........... , ........ D D 0 D Suit!!: type/IOC2ltlll'n unavailable. D D D D Smoking preference u!'klvallable D D D D stan' cont41ctjservlce ............... D D D D Telephone .............................. D D D D lV/remote net wor1clng ........... D D D D Wake-up aU .......................... D D D D Other (pleast s~cJfy below) ... D D D D

9. Which ~ ot the following best descnbes the primary purpose of your trip to this Residence Inn7

PrOJttCt aSsignment ...... ....... 0 Relocatlon/lnterlm housing.. 0 Tr.Jlnlng .................. ........... 0 VJsJUil9 trlends./RI!I;:allves ..... 0 S.atC$ c;,!1... 0 Other leisure ilI:Uvlties .. ...... 0

,,< ....... _l!!.,,"~ meeflng . ............ 0 O~her (ple:Js(! specify below) 0 COI1l1entJon/COtlference ....... 0

/-let your expectatIons ............................ 0 Old not med your expectations ............... 0

11, In the last twelve months, how many overnight business trips did you take? (PlUS!! wrlCe one numbt:r.)

---"'P' 12. How many of these triPS lasted 5 or more consecutive

nights In the same accommodation?

____ Trips

13. How many of the trlps that lasted 5 or more consecutive nights were to any ResIdence Inn?

____ Tops

14. In tile Jilst twelve monthl>, how many overnight leisure trIps did you I:clke? (Plei.lSfl wrJ(e one number.)

____ TrIps

15, Was this your flrst visit ever to tblD Residence Inn7

Yes ......... ". 0 No ........... 0 16. Was ResIdence Jnn your first choice (or this trip?

Yes ............ 0 No ........... 0 17. Based on your stay at this ResIdence Inn, how Itkely would

you be to stay at other ResIdence: Inns?

DMinltely WJII

D

Probably Will

D

18. WhOt Is your age, please?

Under 18 18-34 35-44

D D D

Mayor May Not

D

45-54

D

Probably WJIl Not

D

55·64

D

Dennltdy WIlJ Not

D

65 or Olle(

D 19. Areyau: Female .......... ,. 0 Male ........... 0 20. Daytime phone number?

(000) 000 - 0000 21. E-mail address?

000000000000 000000000000 000000000000

Please provldo u.s with any additional comments you may have about your stay. feel free to Indude: an additional pleco ot paper It nec.e.ssary.

-16-

Exhibit 6

Comprehensive Process Audit

Human-Resources Best Practices

I. Personnel files (e.g., reviews, discipline, tax forms) are properly maintained .

. 2. Associates adhere to training schedules.

3. Uniforms are worn per policy.

UV0225

4. Hotel complies with human-resources regulations (e.g., OSHA, ADA, Workers' Compensation).

Hotel-1m provement Best Practices

1. Associates are aware of mission statement, critical success factors.

2. Guest rooms and public areas are properly cleaned and inspected.

3. Defects and guest complaints are properly recorded and resolved.

4. Sales and marketing goals are posted and results tracked properly.

5. Hotel adheres to accounting and internal-control processes.

Maintenance Best Practices

I. Guest rooms and public areas are refreshed with quarterly preventive maintenance.

2. Major equipment items are maintained according to schedule.

3. Inspections (e.g., fire, elevator, health) are kept current.

4. Pool readings are conducted and logged correctly.

5. Capital-expenditure file is maintained correctly.

-17- UV0225

Exhibit 7

Comprehensive Scorecard Results

Section 1: Balanced Scorecard Results

1997 1998 1999

. - ........................ Maverick Lodgine yield vs. brand average yield ~ percentage of brand average yield; growth in Maverick Lodging yield

Maverick Courtyard vs. Average Courtyard 114.3% vs. 112.2% - 101.87% 116.7% vs. 113.3% - 103.00%; 121.1% vs. 116.5% - 103.95%; 2.10% growth . 3.77% growth

1'vlaverick Fairfield Inn vs. Average Fairfield 1 Hl.l % vs. 111.3% - 98.92% 112.6% vs. 111.9% -100.63%; 115.1%vs.ll1.0%-103.69%; Inn 2.27% growth 2.22% orowth

flrlaverick Residence Inn vs. Average 119.3% vs. 123.9% - 96.29% 122.7% vs. 123.5% - 99.35%; 127.0% vs. 124.3% = 102.17%; Residence Inn 2.85% growth 3.50% growth

-"_ ... hrou2:h Flexib -- --- -.

Actual house profit as a percentage of budget house profit; actual controllable profit as a percentage of fleXible-budget controllable profit Ivfaverick Courtyard N/C (not calculated) N/C 107.1%; 100.9% IVfavcrick Fairfield Inn N/C . N/C 88.5%; 101.1%

--M~yerick Residence Inn· N/C N/C 100.7%; 101.1%

-

I Guest-Satisfaction Score l\'1a,\erici{ Loc!ging: overall guest score vs. brand average Guest score; chancre in Maverick Lodging truest score

t-.llaverick Courtyard vs. Average Courtyard 82.1 vs. 83.0 (bottom 50%) 85.9 vs. 83.0 (top 30%) 85.1 vs. 82.6 (top 40%) 4.63% increase -0.93% decrease

Maverick Fairfield Inn vs. Average Fairfield 94.0 vs. 91.5 (top 30%) 89.2 vs. 86.2 (top 40%) 86.3 vs. 85.3 (top 50%) Inn ~5.11 % decrease ~3.25% decrease

Maverick Residence Inn vs. Average 90.2 vs. 84.6 (top 20%) 89.7 vs. 83.5 (top 20%) 87.0 vs. 82.8 (top 30%) Residence Inl1 -0.55% decrease -3.01% decrease

- - - -_ .. - -- -- -- -

Comprehensive Audit Performance IntcrnaJ-Drocess-audit score N/C 88.3 95.3

Maverick Lod '5 Turnover Associate turnover; change in turnover 85.4% 69.9%; 18.15% reduction 61.3%; 12.3% reduction

-\8- UV0225

Exhibit 7 (continued)

Section 2: Other Results

1997 1998 1999

Revenue Performance RevPAR:

Consolidated RevPAR $54.05 $58.88 $62.74 Growth in RevP AR Not available 8.94% growth 6.56% arowth

Yield: Consolidated yield index 115.5% 118.8% 120.4% Growth in yield Not available 2.86% growth 1.35% growth

Profitability Performance Hohse-profit percentage' compared with Marriott avera es

Maverick Courtyard vs. Average Courtyard 48.3% VS. 53.6% 52.2% VS. 54.3% 54.1 % vs. 54.0% Maverick Fairfield Inn vs. Average,Fairfield Inn 54.9% VS. 51.9% 54.9% VS. 48.9% 54.6% vs. 45.8% Maverick Resjden~~J!!!!ys. Average Residence Inn 53.8% Y$. 53.5% 57.0% VS. 54.3%

- ~~_~_?_~ vs~~}A%

Maverick Lod '5 Turnover Manager turnover; change in turnover 32.6% 20.9%; 35.89% reduction 24.3%; 16.27% increase

Note: The 'balanced scorecard was implemented during 1998, but managers were not evaluated on the balanced scorecard results'until 1999. Maverick Lodging tracked the majority of these performance measures for 1997 and 1998 for comparative purposes.

I House-profit percentage is house profit/total revenue.

Dragon Development Company

Dragon Development is in the business of building single-family homes. It is currently in the process of developing a tract in which it will offer 20 single-family homes. With the decline in the real estate market, the company has been losing profitability. It wants to regain its profitability by adopting target costing to manage profits and costs. .

The following initial specifications have been worked out for the new tract of homes that will be the pilot for the target cost system.

Foundation/roof area (square feet) 2,800 Heated floor space (square feet) 3,600 Garaqe(square feet) 600 Deck(square feet) 500 Patios/walkwavsllawn (square feefY 5,500 Number of bathrooms 5

The intended buyers for these homes are professional, upper middle class families (lawyers, doctors, accountants, managers, small business owners, EMBAs, etc.) in which both spouses typically work. The quality specifications are designed to meet the expectations of this class of buyers.

Target Profit and Prices It is customary for developers to aim for a 20 percent contribution margin from each house net of the marketing and sales commissions. These latter costs are approximately four percent of the selling price. That is, is a house sells for $200,000, the net price to the developer is $192,000 and the desired contribution margin is $38,400. Recent market surveys indicate that a house with the proposed quality and design specifications will sell for around $399,000. This represents a drop in price reflecting the recent decline in real estate values in general. When the design and specifications were originally conceived, these homes were selling in the $450,000 range. The company has come to the conclusion that it will be difficult to achieve the 20 percent desired profit margin with the lower price of $399,000.

Cost History and Estimates The initial cost estimates suggest that the total development cost will be much higher than the price the market is willing to pay. Besides cOAstruction cost, the new homes are expected to have land cost of $70,000 per home and construction financing of seven percent per annum, with a typical construction period of none months. These estimates are based on using, as a starting cost estimate, the cost of a recent housing tract with similar quality homes. The table below provides the specifications for a typical home (609 Courtney Drive) in this recently completed tract.

Construction Specifications 609 Courtney Drive (Two-story home)

Foundation/roof area (square feet) 1,800 Heated floor sjlace (square feet) 2,935 Garage ~quare feetl 490 Deck (square feet) 500 Patios/walkways/lawn (square feet) 5,300 Number of bathrooms 3

While 609 Courtney Drive is smaller than the proposed tract's houses, its quality is similar. The costs of building 609 Courtney Drive are detailed in the following table:

2

Table A Construction Cost - 609 Courtney Drive

ITEM COST Architectural fees $7,500 Interior and landscape design 1,500 Building permits 5,253 Construction insurance 235 Temporary facilities 750 Water meter and utility trench 488 Excavation 750 Concrete forms 1,500 Concrete for foundation and floors 8,500 Roof coverin~ 4,750 Garage door and opener 650 Site cJeanup_ 500 Lumber for rough framing 17,500 Lumber, finish lumber for door/window trims and moldin~ 8,944 Framing labor 22,225 Carpentry finish (installing cabinets, trims, etc.) 6,375 Doors and frames 3,453 Windows and sashes 6,413 Stucco exterior 8,025 Sheet rock (gypsum board for interior walls) 8,763 Rou~h electrical wirin~ 5,013 ROLl9.h fJlumbing 7,975 Telephone wiring 413 Cost offraming changes and bonus for on-time finish ·1,405 Bathroom and kitchen cabinets 7,856 Hardware for framing 900 Hardware finish (door knobs, hinges, etc.) 1,719 Plumbing finish 2,519 Electrical finish (wall switches, plates, etc.) 4,954 Light fixtures 3,591 Heating and ventilation (equipment plus labor) 6,125 Built-in window planter boxes 1,044 Insulation 4,825 Finish flooring (carpeting and tile 1. 13,343 Built-in kitchen appliances 5,616 Spiral stairway - metal 2,319 Mirrors, towel holders, etc. 1,250 Fireplace 1,690 Subtotal carried forward $186,631

3

Table A Construction Cost - 609 Courtney Drive, continued

ITEM COST Balance carried forward $186,631 Blinds and shutters for windows 3,381 Paintinij and wallpaper 7,925 Garage cabinets 438 Tile work (materials and labor) . 6,181 Fencing 725 Concrete driveway and walkways 5,129 Plants and lawn 4,606 Sprinkler system 956 Total Cost $215,972

CustomerlCompetition Analysis To make trade-offs intelligently, the company has commissioned a market survey that shows the relative values customers place on different "hard" and "soft" functionalities in a home. The survey also ranked competitor offerings on these same functionalities .. This data was arrayed in a Quality Function Deployment (QFD) matrix so all relevant data could be related to the design parameters. The QFD matrix is shown in Table B (see separate file).

4

Value Engineering To make design changes the company formed a team consisting of the architect, interior designer, structural engineer, and framer to develop some value engineering ideas for cost redesign. The team came up with a set of ideas to guide them through the specific changes they wanted to consider. These ideas are summarized in Table C.

Table C, Part 1 Value Engineering - Brainstorming Starters

ADAPT What else is like this? Does the past offer similarities? What could we copy? What other ideas does this support?

COMBINE Can we combine? Combine purposes? Combine ideas? Combine functions?

MAGNIFY What can we add? Thicker? More frequent? Stronqer?

MINIMIZE What can we subtract? Smaller? Omit? Streamline?

REARRANGE Can we interchange? Different layout? Different sequence? Change pace? Different pattern? Different schedule?

REVERSE· What's the opposite? Can we tum it around? Upside down, backward? Can we reverse roles?

MODIFY Can we chanqe the color, form, shape? What new twist?

SUBSTITUTE What can we use instead Who else can? Another approach? Another material?

5

1. 2. 3. 4. 5. 6. 7. 8. 9.

10.

Can we do without it?

Table C, Part 2 Test for Value

Does it do more than the customer requires? Can we use other materials? List them Does a specialty vendpr have it for less? Is there a simpler way of doing the job? Can somebody's standard item be used? Could less costly tooli~g or fixtures be used? Does it cost more than we feel is reasonable? Are we buying too much reliability? Using~ money, would I refuse the [lrice?

YES NO

REQUIRED: 1. Prepare an initial cost estimate for the proposed home, using 609

Courtney Drive as a cost model. (Hint: you may want to group costs by common drivers and then use these drivers to predict the new tract's costs)

2. Using the target prices and desired margin, develop a target cost for the new housing tract. How far is the target cost from the initial cost estimate?

3. Develop a cost reduction strategy for the company that considers the lifetime ownership costs to the customer and will allow Dragon to meet the target cost for the new tract (including land and financing). Use the value engineering ideas in Table C and customer preferences in Table B as a guide. However, if you need to make additional assumptions, state them in your analysis.

4. Briefly explain each major cost reduction strategy you have adopted. Indicate the quality and functionality trade-offs you have used to meet the target cost and defend these tradeoffs.

6

I Customer

Requirements

I Spacious fcelin_!!. inside Adequate bathrooms Good usc of space Fully equipped kitchen Lots of storage soace Bonus room or library Easy to maintain housc!yard Lots of decks and balconies Earthquake and fire safe High quality cabinets Burgiarllirc alarms Wood or marble floor finish Decorative finish Fireplaces Roofing looks tile vs. Oat. etc.

Key to Symbols:

TABLEB QFD Matrix for Proposed Home

****"""'''''''''''''''><'1':****************Design Parameters*"''''''''''****************'''************ Square Number One Electric

Feet Of Vs. Wiring Baths Two

Floors M I M S S S

S S W S

W S

I S I

I S I

I I

W I

I S = Strong correlation M = Medium correlation W = Weak correlation o = Our product C = Competitor's product

Electric F\nishcd Roofing Floor Finish Appliances Carpentry Style Covering Material

:M S

S S W

S

W

W

s w M

S

S s

S

-> numerical rating = 7 -> numerical rating = 4 -> numerical rating = 1

Com elItor Ranking Customer

Rating Low High

I 2 3 4 5 C 0 5 ,

C 0 4 0 C 5

0 C 5 0 C 4

0 C 3 OC 4

OC 2

0 C 5

0 C 3 OC 5

0 C 3

0 C 2 0 C I

0 C I

Shady Hills Golf Course

The Shady Hills Resort and Golf Course has asked you to do a partial capacity analysis of its golf course operation. Your analysis will focus solely on the golf course; ignore the practice facilities, tennis courts, pool, and clubhouse food and drink service operations. . .

Shady Hills is an exclusive resort that encourages serio LIS golf. The pace of play is set at four hOllrs for 18 holes. Nine-hole play is not permitted until 3:00 P.M. in the winter months and 4:00 P.M. in the summer. Tournaments use a "shotgun start" (all golfers start at the same time with as many as 32 groups of four possible for a tournament). All other play begins at the first tee. The course finds it can enforce the pace-of-play rules by scheduling tee-off times eight minutes apart and every hour reserve one "four-minute starter's time" (when no group is scheduled). No more than four golfers may play in a group.

Shady Hills is located in the South and is open for play (weather permitting) all year. During the winter months (November - March) play begins at 8:00 A.M. and all players must be off the course by 7:00 P.M. In the summer (April­October) play starts at 6:30 A.M. and continues until 8:30 P.M.

Your analysis shows that weather will cause the course to close (or delay.play) an average of 290 hours a year. The course does not refund greens fees when there is bad weather, but will allow the individual the option of playing a round for half price if bad weather set in before nine holes were completed. Approximately 800 rounds a year are played under this arrangement. In addition, the course is physically closed for extensive maintenance one week a year during the winter season. Other regular maintenance on the greens and fairways has the effect of reducing play by 50 percent for three additional weeks a year (one week each in

April, June, and August) even though the course is open. During these periods the greens fees are reduced by 25 percent to encourage play.

Because this is a resort course, it is open for play by resort· guests. However, approximately once a week the resort pro schedules tournaments that effectively close the course. Twenty-six of these tournaments start at 8:00 A.M. and end at 12:30 P.M. The remaining tournaments start at either 12:00 Noon or 1 :00 P.M., depending on the time of year, with regular play resuming at 4:30 or 5:30 P.M.

During the winter season, the course has an average of 160 players complete a round each day, exclusive of tournament play. Winter tournaments average 110 players. During the summer months of April, May, September, and October, play averages 230 players, exclusive of tournaments. During this time there are 90 players per tournament. June, July and August are very hot, and play falls to 170 per day and 100 players per tournament.

A typical round of golf for a resort guest costs $80, while non-resort guests must pay $100. The ratio of guest to non-guest play is 3 to 1. For a tournament, the fee is typically $120 with about half the entry fee given back to participants in pro shop credit. All rounds include cart fees that average $12.50 a person at other nearby courses.

The cost of rnaintaining the course, cart upkeep, pro shop help, rnarshals, and other costs for a year are budgeted at $4,000,000. This does not include charges for the cost of the land, but does include a facility depreciation charge of $2,000,000 annually.

REQUIRED:

1. Make a preliminary analysis of the hours the course is in use, idle, and non-productive, using the CAM-I capacity model. Explain any assumptions.

2. Extend your analysis to the revenue potential of the course under current operating conditions and at capacity operations.

3. How would you analyze the cost of a round of golf under current operating conditions?

4. What operating and/or policy changes would you suggest to increase the revenue potential of the course?

HARVARD BUSINESS SCHOOL

9-158-001 REV: JANUARY 2, 2003

Birch Paper Company

If I were to price these boxes any lower than $480 a thousand, I'd be countermanding my order of last month for our salesmen to stop shaving their bids and to bid full-cost quotations. I've been tnjing for weeks to improve Ihe quality of our business, and if Ilu/'/1 arnund now ond accept Ihis job 01 $430 01' $450 01' somelhing less Ihan $480, I'll be tearing down this program I've been working so hard to build up. The division can't venJ well show a profit by putting in bids which don't even cover a fair share of overhead costs, let alone give us a profit.

- James Brunner, Manager of Thompson Division

Birch Paper Company was a fl1edium-sized, partly integrated paper company, producing white and kraft papers and paperboard. A portion of its paperboard output was converted into corrugated boxes by the Thompson Division, which also printed and colored the outside surface of the boxes. Including Thompson, the company had four production divisions and a timberland division that supplied part of the company's pulp requirements.

For several years each division had been judged independently on the basis of its profit and return on investment. Top management had been working to gain effective results from a policy of decentralizing responsibility and authority for all decisions except those relating to overall company policy. The company's top officials believed that in the past few years the concept of decentralization had been successfully applied and that the company's profits and competitive position had definitely improved.

Early in 2002 the Northern Division designed a special display box for one of its papers in conjunction with the Thompson Division, which was equipped to make the box. Thompson's staff for package design and development spent several months perfecting the design, production methods, and materials that were to be used. Because of the box's unusual color and shape, these were far from standard. According to an agreement between the two divisions, the Thompson Division was reimbursed by the Northern Division for the cost of its design and development work.

When the specifications were all prepared, the Northern Division asked for bids on the corrugated box from the Thompson Division and from two outside companies. Each Birch Paper Company division manager normally was free to buy from whatever supplier he wished; on inter-company sales, divisions selling to other divisions were expected to meet the going market price.

HBS cases are developed solely as the bilsis for class discussion. Cases arc not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

Copyright © 1957 President and Fellows of Harvard College. To order copies or request pennission to reproduce materials, call1-BOO-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No pnrt of this publication may ~e

- _. "--"'"~ •. - ',eproduced, -stored - fir a 'retrieval' system, used in a spreildsheet, or tmnsmitted in' any fonn or by--any -Ineans'-'-'electronic; mechanical, photocopying, recording, or otherwise-without the permission of Harvard Business School.

158-001 Birch Paper Company

In 2002, the profit margins of converters such as the Thompson Division were being squeezed_ Thompson, as did many other similar converters, bought the paperboard and linerboard used in making boxes, and its function was to print, cut, and shape the material into boxes1 Although it bought most of its materials from other Birch divisions, most of Thompson's sales were made to outside customers_ If Thompson got the order from Northern, it probably would buy its linerboard and corrugating medium from the Southern Division of Birch. Thus, before giving its bid to Northern, Thompson got a quote for materials from the Southern Division. Although Southern had been running below capacity and had excess inventory, it quoted the prevailing market price for materials. Southern's out-of-pocket costs for both liner and corrugating medium were about 60% of its selling price. About 70% of Thompson's out-of-pocket costs of $400 per thousand boxes represented the cost of linerboard and the corrugating medium.

The Northern Division received bids on the boxes of $480 per thousand from the Thompson Division, $430 per thousand from West Paper Company, and $432 per thousand from Eire Papers, Ltd. Eire Papers offered to buy from Birch the outside linerboard with the special printing already on it, but it would supply its own inside liner and corrugating medium. The outside liner would be supplied by the Southern Division at a price equivalent to $90 per thousand boxes, and would be printed for $30 per thousand by the Thompson Division. Of the $30, about $25 would be out-of­pocket costs.

Since the bidding results appeared to be a little unusual, William Kenton, manager of the Northern Division, discussed the wide discrepancy in the bids with Birch's commercial vice president. He told the vice president, "We sell in a very competitive market, where higher costs cannot be passed on. How can we be expected to show a decent profit and return on investment if we have to buy our supplies at more than 10% over the going market?"

Knowing that Mr. Bronner had been unable to operate the Thompson Division at capacity on occasion during the past few months, it seemed odd to the vice president that Mr. Bronner would add the full 20% overhead and profit charge to his out-of-pocket costs. When he asked Mr. Bronner about this, the answer he received was the statement that appears at the beginning of the case. Bronner went on to say that, haVing done the developmental work on the box and having received no profit on that work, he felt entitled to a good markup on the production of the box itself.

The vice president explored further the cost structures of the various divisions. He remembered a comment of the controller at a meeting the week before, to the effect that costs which were variable for one division could be largely fixed for the company as a whole. He knew that in the absence of specific orders from top management Mr. Kenton would accept the lowest bid, which was that of the West Paper Company for $430. However, it would be possible for top management to order the acceptance of another bid if the situation warranted such action. And although the volume represented by the transactions in question was less than 5% of the volume of any of the divisions involved, future transactions could conceivably raise similar problems.

1 The walls of a corrugated box consist of outside and inside sheets of linerboard and a center layer of fluted corrugating medium.

2