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1. Allocate manufacturing overhead to divisions. Specificoverhead items should be allocated on an individual basis whenthere is a logical basis for doing so.
2. Develop overhead application rates for the three divisions onthe basis of production volume.
3. Calculate the direct cost of the Impendiam job.
4. Calculate the absorption cost of the Impendiam job.
5. Calculate the full cost of the Impedium job.
6. As Baumberg, what additional factors would you considerbefore recommending a bid price for the Impending contract?
7. What price would you recommend that Sparrow bid for theImpendingcontract?
8. Assume that Sparrow is projected to operate at 90% capacity.Using this assumption, recalculate Sparrow's direct cost,absorption cost, and the full cost for the Impendin Chemicals joborder. If your were Baumberg, how would these recalculated costschange your pricing decision?
IVEY| Publishing For the exclusive use of T. Gordon, 2021. PROJECT SPARROW: APPLYING COSTING METHODS W21073 Kaitlyn Oh wrote this case under the supervision of lan Dunn solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality This publication may not be transmitted, photocopied, digitized, or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G ON1: (1) 519.661.3208; (e) [email protected]; www.iveycases.com. Our goal is to publish materials of the highest quality, submit any errata to publishcases @ivey.ca. Copyright © 2021, Ivey Business School Foundation Version: 2021-03-01 It was August 20, 2019, and Emily Baumberg, a newly promoted project manager at Roland Berger, had just settled into her seat in the conference room. Baumberg was reflecting on her four-year career at the global management consulting firm when she heard a knock on the door. She was currently staffed in Houston, Texas, on a three-month project with Sparrow GmbH (Sparrow), a small-scale chemical manufacturer. The door creaked open, and Sparrow's pricing manager entered with a warm cup of coffee for Baumberg. The pricing manager also requested a small favour. Although Baumberg and her team were focused on optimizing costs at Sparrow's production facilities, the pricing manager had heard that the team was thinking about Sparrow's cost structure in a new way. He thought this knowledge could help him to determine a more competitive bid price for Sparrow's chemicals contract with Impendium Chemicals (Impendium), one of Sparrow's top customers. Baumberg chatted with the pricing manager as they sipped their coffee, and she agreed to provide him with a winning pricing strategy by the end of the week. SPARROW GMBH Sparrow was a chemical manufacturer based in Germany. The company had two main product categories: basic chemicals and specialty chemicals. Basic chemicals were commodity chemicals derived from oil and petroleum by-products. These products were manufactured in large volumes, with minimal product differentiation from producer to producer. Specialty chemicals were hardened or cured polymers, similar to plastic. The specialty chemical division manufactured unique products based on Sparrow's patented manufacturing processes and formulations. Sparrow's basic and specialty chemical divisions were not related to each other. Sparrow currently had two manufacturing facilities: one located in the United States and one located in Germany. The German facility manufactured both basic and specialty chemicals, while the US plant manufactured only basic chemicals. A Gesellschaft mit beschränkter Haftung (abbreviated GmbH) was a private company with limited liability, usually found in Germany, Austria, Switzerland, and Liechtenstein. This document is authorized for use only by Thomas Gordon in Fall 2021 Acct 495 taught by Nicole Renee McCoy, North Carolina A&T State University from Aug 2021 to Dec 2021.
Page 2 For the exclusive use of T. Gordon, 2021. 9B21B003 SPARROW'S PRICING STRATEGY FOR THE IMPENDIUM BID Sparrow underwent a bidding process for all of its chemical contracts. Each customer would re-evaluate its chemical pricing at least once per year and would typically choose the most price-competitive offer. Customers were generally price-conscious and switched suppliers quickly if a different supplier offered significantly lower prices while maintaining customer service and reliability. Impendium was one of Sparrow's largest basic chemicals customers and had purchased chemicals exclusively from Sparrow for the past two years. However, in an effort to cut costs, Impendium's board of directors was pressuring the company to consider multiple suppliers. The pricing manager had previously priced the contract based on the salesperson's recommendations and his own costing estimates. However, with the additional pressure to lower prices, the pricing manager wanted to ensure that Sparrow's pricing strategy would win the bid. To help Roland Berger develop a pricing strategy, the pricing manager had provided the monthly job cost sheet for Impendium's order (see Exhibit 1). MARKET DYNAMICS Sparrow was one of the smallest basic chemical producers in an industry where the four largest players controlled 80 per cent of the global production capacity. Unlike Sparrow, these large players converted basic chemicals into more complex products and, as a result, were often able to generate much higher profit margins. Customers had access to the global average price of basic chemicals, which they often used as a benchmark when selecting suppliers. The main determinant of the global average price in the basic chemicals industry was the global capacity utilization rate. In the past decade, a few companies in Asia had expanded their capacity by adding new facilities, resulting in a decline in the capacity utilization rate and all-time low basic chemical prices.² Global basic chemical prices had since stabilized at USS3,450 per kiloton at an industry capacity utilization rate of 70 per cent. For the price to increase, experts estimated that the industry would need to improve the capacity utilization rate to 80 per cent to reach basic chemical prices of $4,350 per kiloton. SPARROW'S BASIC CHEMICAL COSTS Baumberg and her team needed to decide how to estimate Sparrow's cost structure. Baumberg had been given access to Sparrow's projected costs for fiscal year 2020, but the projections included both specialty chemicals and basic chemicals (see Exhibit 2). Baumberg and her team would need to determine the best way to allocate the costs to determine the allocation rates for the job cost sheet. 2 Company files. 3 All dollar amounts are in US dollars. 4 Company files. Ibid. The US basic chemicals facility was much newer than the German facility, although it had a much lower capacity. The US facility was built eight years ago, while the German facility was built 18 years ago. The US basic chemicals facility had one reactor with a capacity of 150 kilotons, while the German basic chemicals facility had a cumulative capacity of 250 kilotons. Both basic chemical plants were expected to continue operating at 60 per cent utilization rate. The German specialty chemicals facility had a much larger capacity of 600 kilotons and was expected to operate at a 75 per cent utilization rate. This document is authorized for use only by Thomas Gordon in Fall 2021 Acct 495 taught by Nicole Renee McCoy, North Carolina A&T State University from Aug 2021 to Dec 2021.
For the exclusive use of T. Gordon, 2021. Page 3 Regardless of their utilization rate, the reactors would require a proportionate amount of power and supplies based on their capacity to operate. The best estimate for repairs expenses was the proportionate age of the machinery. 9B21B003 Sparrow owned all of its production facilities and associated assets. The US basic chemicals plant, including the reactors, originally cost $60 million, whereas the German basic chemicals plant cost $70 million, and the German specialty chemicals facility cost $160 million. All buildings and machinery were depreciated using the units of output method based on the expected production. In contrast, Sparrow's insurance policy on the manufacturing assets was based on the historic cost of the assets. The budgeted direct labour cost of $279,450 comprised $9,450 for the US basic chemicals plant, $22,500 for the German basic chemicals facility, and $247,500 for the German specialty chemicals department. In addition, each factory had a factory supervisor. In the United States, the supervisor was paid $50,000. In Germany, one supervisor for each business division was paid $75,000 (see Exhibit 3). The costs shown for shipping and receiving were to be spread evenly across each division. Although Sparrow owned its production facilities, it did rent raw material warehousing space. In the United States, Sparrow rented 15,000 square metres of warchouse space. In Germany, Sparrow rented 35,000 square metres for basic chemicals and 90,000 square metres for specialty chemicals. In addition, Sparrow rented an office space in the United States for $30,000 per year. Sparrow employed two salespeople. One salesperson focused on the basic chemicals sales, while the second salesperson focused on selling specialty chemicals. Sparrow also employed one general manager who oversaw both basic and specialty chemicals. In her research, Baumberg noticed that many industry experts were forecasting higher capacity utilization rates in the basic chemicals industry due to expected plant closures. Most experts agreed that basic chemical utilization rates would increase to 80 per cent in the next year. Baumberg had reason to believe that many of the displaced customers from the plant closures would purchase their basic chemicals from Sparrow. As a result, Sparrow's basic chemicals capacity utilization rate would increase to 90 per cent. Baumberg wanted to understand the implications on the Impendium bid if utilization rates increased. In this scenario, Baumberg estimated that Sparrow's basic chemicals direct labour costs would increase to $14,175 in the United States and $33,750 in Germany, and the direct material costs would increase to $78,975 in the United States and $253,125 in Germany. The specialty chemicals division would remain unchanged. Baumberg sat down to complete the analysis for Sparrow's pricing manager. To begin, she wondered what Sparrow's costs were for each of its divisions. She was concerned about which factors should be taken into account in addition to the costs and how to advise the pricing manager. Baumberg had only a few days to put together her analysis before her flight back home to Boston on Thursday evening, and she was eager to give the pricing manager an answer. This document is authorized for use only by Thomas Gordon in Fall 2021 Acct 495 taught by Nicole Renee McCoy, North Carolina A&T State University from Aug 2021 to Dec 2021.
Page 4 Company Name To: Impendium Chemicals 1225 Industrial Parkway Houston, TX 77029 Department US Basics Germany Basics Germany Specialties Total EXHIBIT 1: IMPENDIUM CHEMICALS JOB COST SHEET Volume (kt) 10.0 15.0 1.0 26.0 Material Cost (per kt) $ 585.00 $1,125.00 $1.698.00 Labour Rate (per kt) $ 105.00 $ 150.00 $ 550.00 Note: All dollar amounts are in US dollars; kt = kiloton. Source: Created by the case writers. For the exclusive use of T. Gordon, 2021. Direct labour Direct material Supervision General manager's salary Supplies Shipping and receiving Power Warehousing rent Office rent Job Cost Sheet Invoice # 100 Date: September 1, 2019 Depreciation Cost (per kt) $415.00 $ 275.00 Cost $ 11,050.00 $ 23,250.00 EXHIBIT 2: SPARROW GMBH'S BUDGETED COSTS FOR 2020 (US$) $ 279,450 985,500 200,000 140,000 21,000 34,500 140,000 120,000 30,000 225,000 24,000 63,000 $325.00 $ 2.573.00 $36,873.00 9B21B003 Overhead Applied 70,000 33,500 Total Depreciation on machinery Insurance on machinery Repairs Selling expenses Administrative expenses Note: To calculate depreciation on machinery, Sparrow used the units of output method based on kilotons of chemicals produced. The US reactors were depreciated at a rate of $415 per kiloton. The Germany basic chemical reactors were depreciated at a rate of $275 per kiloton, and the Germany specialty chemical reactors were depreciated at a rate of $325 per kiloton. Source: Created by the case writers. This document is authorized for use only by Thomas Gordon in Fall 2021 Acct 495 taught by Nicole Renee McCoy, North Carolina A&T State University from Aug 2021 to Dec 2021.
Page 5 Direct Costs: Direct labour Direct material EXHIBIT 3: SPARROW GMBH'S ANNUAL COST ASSIGNMENT AND ALLOCATION WORKSHEET (US$) Depreciation on machinery Total direct costs Factory Overhead Costs Supervision Supplies Power Warehouse rent Insurance on machinery Repairs Total factory overhead costs Administrative Costs General manager Shipping and receiving Office rent Selling expenses Administrative expenses Total administrative expenses Overhead Application Rates Factory overhead application rate (FOH expenses + Production volume) Total overhead application rate (Total expenses + Production volume) Note: FOH = factory overhead. Source: Created by the case writers. For the exclusive use of T. Gordon, 2021. Total $279,450 985,500 224,850 $1,489,800 $ 200,000 21,000 140,000 120,000 24,000 63.000 $568,000 $ 140,000 34,500 30,000 90,000 30,000 $ 324,500 US Basics 9B21B003 Germany Basics Germany Specialties This document is authorized for use only by Thomas Gordon in Fall 2021 Acct 495 taught by Nicole Renee McCoy, North Carolina A&T State University from Aug 2021 to Dec 2021.