Recommended Corporate Strategy for Moonsnail - Case Study Example

title page) Recommended Corporate Strategy for Moonsnail Currently, Moonsnail is part of an industry comprising several similar-sized competitors producing similar soaps, bath, and personal care products of comparable quality, operating within a relatively small market in Eastern Canada and the Northeast United States. If considered in terms of Porter’s Generic Strategies, the entire industry is using a Focus strategy, leaving Moonsnail with the choice of either pursuing a Low-Cost or a Differentiation strategy. Since the critical question facing Moonsnail right now is whether or not the production and sale of Moonsnail Babycream is a financially wise move, the implication is that a Low-Cost focus is best for the company. Porter’s Generic Strategies, however, are only good for identifying a strategy and no help at all in developing the details, so for that another model must be used. (Sims, 2001) Porter’s Value Chain is a good choice for this, because it considers the full range of Moonsnail’s business activities, and the cost drivers associated with and generated by each of them. (Collier, 2006: 121) The value chain model for Moonsnail thus looks like this: Fig. 1: Moonsnail Value Chain The Role of Management Accounting in Strategy Formulation Each of the activities shown in Moonsnail’s value chain on page 1 has one or more cost drivers which ultimately affect the margin that Moonsnail can take from its Babycream or any of the company’s other products. The reason management accounting is important in the formulation of strategy is that it provides a common assessment metric which can be applied in both a historical and forward-looking manner to each of these activities, even ones that do not have an obvious financial definition, such as merchandising or customer service activities. In the historical sense, management accounting can describe current or past costs and help to identify where costs can be reduced, and describe the impact of these costs in terms of a percentage of the margin. Once that impact is understood, forward planning can be done because the effects of planned changes and activities will have a known quantitative result. This is a more internal focus for management accounting than has been traditionally used, but one which some research has indicated is more appropriate. (Collier, 2006: 49) Financial Analysis of Moonsnail Babycream The variable costs for a unit of Moonsnail Babycream, as calculated in the following section, are $1.75/unit. Production of Babycream is estimated to account for 10 to 15 percent of total direct labour, and the total fixed costs based on the 2000 budget statement are $38,091. The projected retail volume of Babycream for 2001 is 1,000 units. Using the Marginal Cost method, the contribution of this volume of Babycream at the projected retail price of $9.95/unit is: [at 10% of total labour] $9.95 revenue - $1.75 variable costs per unit = $8.20 contribution per unit $8,200 total contribution - $3,809.10 fixed costs = $4,390.90 positive contribution At 15% of total labour, the fixed costs are increased to $5,713.65 and the net contribution is reduced to $2,486.35. The estimated wholesale potential of Moonsnail Babycream is an average of 35 units per month from 10 accounts at a wholesale price of $6.00/unit. This yields a yearly volume of 4,200 units with a per-unit contribution of $4.25, or $17,850 total. The production of this many units, however, will increase the proportion of labour devoted to the production of Babycream; 4,200 units at 0.14 hours/unit is equal to 588 hours. Assuming that these hours will have to be added to the total direct labour hours, and that the 1,000 retail units account for 10% of the existing total labour hours, the total proportion of labour hours for the production of 5,200 units is 37%. Therefore: $8,200 total retail contribution + $17,850 total wholesale contribution - $14,093.67 total fixed costs = $11,956.33 positive contribution This is good news for Moonsnail Babycream; at the projected volumes and retail and wholesale pricing, the product appears to be a profitable concept. It is forecast that a 20% reduction in price will result in a 15% increase in volume. Assuming that is an accurate projection, the proportion of total labour hours would increase to 47%, resulting in: $9,154 total retail contribution + $23,184 total wholesale contribution - $17,092.77 total fixed costs = $14,435.23 positive contribution This is still good news, but the one problem that remains to be analysed is the effect of the labour required for the production of Babycream on Moonsnail’s other products. If Babycream is to be produced in these volumes, additional labour will have to be employed to maintain the production of all other products at current levels, and this will of course have to be carefully managed. Rationale for the Management Accounting Technique In the following section, Moonsnail Babycream is analysed using the Overhead Allocation Method, but there is a significant discrepancy found in the calculation of labour hours between the estimate from total labour costs and the observed labour hours. Using the marginal costing method, where the relevant overhead contribution is simply based on a percentage estimate of labour time regardless of actual labour hours or costs, avoids the discrepancy. Marginal costing is also one of the more effective methods for short-term business decision-making, such as deciding whether or not to launch a new product as in this case. (Weetman, 2006) Product Cost Comparison: Overhead Allocation Method In order to use the overhead allocation method to make a cost comparison of the different product groups, an appropriate cost driver such as labour hours must be selected. Since the number of labour hours spent in the production and packaging of the various products is not specifically given, the assumption will be made that the direct labour dollar totals given in the 1999 income statement addendum are divisible by a constant rate of $6.50 per hour: Soap Creams/Oils Balms/Salves Bought-In Products Direct Labour Total $1,369 $4,130 $2,002 $0 Direct Labour Hours 210.6 635.4 308.0 0.0 Fig. 2: Direct Labour by Product Class Dividing the total overhead from the 1999 income statement by the total number of direct labour hours yields: $30,369 overhead ÷ 1,154 hours = $26.32/direct labour hour By factoring in this overhead rate, the profitability of each product group can be determined: Soap Creams/Oils Balms/Salves Bought-In Products Total Sales $40,275 $24,374 $12,835 $3,091 Direct Materials (Ingredients + Packaging) $2,934 $2,121 $1,220 $1,734 Direct Labour $1,369 $4,130 $2,002 $0 Overhead Allocation $5,543 $16,724 $8,107 $0 Total Cost $9,846 $22,975 $11,329 $1,734 Net $30,429 $1,399 $1,506 $1,357 Margin 75.6% 5.7% 11.7% 43.9% Fig. 3: Profitability by Product Class To determine the cost of Moonsnail Babycream using the overhead allocation method, a number of additional assumptions must be made. First, regarding the product itself (45 grams total per unit), a conversion factor of 1 millilitre = 1 gram will be used for the ingredients. Second, the total direct labour hours will be assumed to remain the same as the figures given for 1999, with the estimate of 10-15 percent being dedicated to the production of Babycream representing a reallocation of labour hours and not an addition to them. To provide as close to a “worst case” in terms of costing as possible, the upper estimate of 15% will be used, and the estimate of 3 hours’ production time per batch will be assumed to be accurate. The recipe for Babycream yields a batch of 986 grams’ total mass, or 22 45-gram units. The total batch and unit costs are: Ingredient Batch Cost Unit Cost Calendula Grape Seed Oil $2.86 $0.13 Chamomile Extract $1.45 $0.07 Rosehip Seed Oil $3.33 $0.15 Vitamin E $0.21 $0.01 Aloe Vera Gel $2.18 $0.10 Distilled Water $0.13 $0.01 Coconut Oil $0.33 $0.02 Beeswax $0.37 $0.02 Total $10.86 $0.49 Fig. 4: Moonsnail Babycream Batch & Unit Costs – Ingredients The jar and labels for each unit cost a total of $0.35 per unit (one jar and two labels), which is added to the ingredients costs to yield a direct material cost of $0.84 per unit. Each unit also requires 0.14 direct labour hours (3 hours ÷ 22 units), which results in a direct labour cost of $0.91. Factoring in the overhead rate of $26.32/hour, this adds $3.68 to the cost, resulting in a total unit cost of $5.43. Product Cost Comparison: Activity Based Costing Method The Activity Based Costing method uses cost drivers based on the activities required to produce some amount of product, whether a batch, the entire year’s production, or a single unit. This can be partially done for Moonsnail’s product groups and Moonsnail Babycream, but can only be done in complete fashion once the full range of activities can be identified and cost drivers for each of them defined. For example, the product ordering activities are not described; some must come from wholesale and retail customers directly and some as a result of production planning, but the proportions of these are not explained, nor the particular actions that occur which would give clues as to what the cost drivers are. Thus, the ABC given here is based solely on production of the products; granted, this likely comprises the majority of the time and resources that have cost inputs on them, but not all, and the margin of error caused as a result cannot be known. According to the observation of the production processes, the break-down of direct labour hours is 50% for production of both creams/oils and balms/salves, 20% for production of soaps, and 30% for packaging and labelling. The total labour hours for creams/oils and balms/salves are given as 253 and 127 hours, respectively, for a grand total of 760 direct labour hours for all production, packaging, and labelling. Each unit of soap requires 10 minutes (0.17 hours) to produce, and each unit of the creams/oils or balms/salves requires 2 minutes (0.03 hours). Of the operating expenses, since there is not a break-down of costs associated with production alone as opposed to other business functions, all are assumed to drive costs proportionally for all products. Utility expenses (for heating), shipping costs for raw materials in and finished products out, and machine maintenance for production equipment are costs that should be separated from the general list of expenses to make the ABC method more accurate. Given these more specific labour time inputs, a basic ABC analysis for the product groups (excluding bought-in products) would be: Soap Creams/Oils Balms/Salves Total Direct Materials $1,162 $1,097 $642 $2,901 Direct Labour Hours 152 253 127 532 Direct Labour Cost $1,369 $4,130 $2,002 $7,501 Packaging Materials $1,772 $1,024 $578 $3,374 Packaging Labour Hours 76 76 76 228 Total Labour Hours 228 329 203 760 Overhead Allocation $6,001 $8,659 $5,343 $20,003 Total Cost $10,304 $14,910 $8,565 $33,779 Units Produced per Labour Hour 6 30 30 -- Total Units 912 7,590 3,810 12,312 Cost per Unit $11.29 $1.96 $2.24 $2.74 Total Sales $40,275 $24,374 $12,835 $77,484 Net $29,971 $9,464 $4,270 $43,705 Margin 74.4% 38.8% 33.3% 56.4% Fig. 5: ABC Analysis of Product Groups Explanation of the Difference in Costs Derived by Each Method The difference in the costs is the result of the discrepancy between the direct labour costs and the actual number of direct labour hours observed. The estimate of labour time in the overhead allocation method is based on the only given labour rate – $6.50/hour – which, in the absence of a record of actual hours, is the only way to calculate them. The implication is that the per-hour labour rate is much higher; based on the results of the ABC method, it would actually be $9.87/hour. One way in which the overhead allocation method could be done differently – since there is really not enough information provided to even bother with attempting to use the Activity-Based Costing method – is to allocate the overhead per unit of the direct labour costs. That makes the overhead allocation equal to $4.05 per $1.00 direct labour, but does not significantly change the results; using this figure, between one and three dollars are added to the total overhead allocations for each of the product categories. This tends to support the contention that the most common way of doing overhead allocation, i.e. by using direct labour hours, is inherently inaccurate (Collier, 2006: 159), making it essential that the correct, required information needed to do an accurate Activity-Based Costing be gathered. Why the Activity Based Costing Method has not been widely adopted in the UK The shortcomings in the analysis for Moonsnail perfectly illustrate why the Activity Based Costing Method has not been widely adopted in the UK or elsewhere. It can be very accurate and provide a clear picture of actual costs, but in order for it to work it must have accurate and detailed inputs. Each activity that has an input on the production and sale of a finished product must be described and have a defined cost driver. For Moonsnail, a list of activities on which costs are based might look like: Activity Cost Driver Generate product order X number of purchase orders (for wholesale) Internal production order (for retail) Order materials X number of out-going purchase orders Plan production X number of labour hours for line set-up, preparation of materials; can be broken down by product Product formulation/preparation X number of labour hours Product packaging X number of labour hours Product shipping/transport X number of units (individual or case lots) Set-up product display/merchandising (for retail) X number of labour hours Fig. 6: Example Activities for Moonsnail Obviously, doing the necessary analysis to first accurately determine the relevant activities and then assigning values to them is quite complex and time-consuming. And of course, doing the analysis is itself an activity which adds a cost. Apparently, many companies who have weighed the option of using ABC have decided that the costs associated with the complex analysis outweigh the potential risk of inaccuracy from using a more basic method like overhead allocation, and have decided on the latter. Analysis of the implementation – or lack thereof – of ABC in companies has found that in most cases management factors such as this are the reason for ABC not being adopted, or not being effective, rather than functional factors of the method. (Majid & Sulaiman, 2008) Strengths & Weaknesses of the Balanced Scorecard The main benefit of using the balanced scorecard is that it is a flexible and reasonably simple way to communicate strategy in such a way as to make it possible to implement and measure it. (Evans, 2002) The strategic objectives of the company are viewed from internal and external perspectives, which provide an opportunity to refine and prioritise them; combined with the three concepts of measurement, targets, and programs/processes that are used to define the strategic objectives, each goal of the company can be broken down into at least 12 easy-to-manage components. While the balanced scorecard is usually described in terms of objectives for an entire company, the flexibility of the system makes it easy to develop balanced scorecards for different areas of the company, so long as they complement the overall plan. The main weakness of the balanced scorecard is that it is not intuitive, and only works as well as the strategic information that is put into it. The management of the company must make the strategic goals specific and measureable. The balanced scorecard can help somewhat, because every goal must be described in terms of financial, customer, internal processes, and growth; but if a particular goal cannot be clearly described, or if a target, measure, or process cannot be conceived for one or more of these perspectives, then the goal must be modified or discarded. Likewise, if there is a target or measurement that cannot be connected to a component of an objective, a more appropriate target or metric must be developed. One of the most common mistakes in designing and trying to use balanced scorecards is choosing measurements that do not really measure what the strategy is calling for. (CIMA, 2001, and Collier, 2006:44) Put another way, the biggest pitfall to using the balanced scorecard is that it is easy to regard it as a strategy-development tool, which it is not. It is rather a framework to effectively translate strategy into action; the balanced scorecard does not save the time or effort required for careful planning, but it can save a great deal of time and effort in implementing the plans. A Balanced Scorecard for Moonsnail The two tables below provide a balanced scorecard for Moonsnail. The balanced scorecard is often depicted as a grouping of four tables, but the two-part arrangement shown here permits a clearer illustration of the details of each component. The four perspectives – financial, customer, internal processes, and growth and learning – are listed in the left-hand column, with the overall strategic objectives shown in the top row. Each intersecting cell, then, shows the relationship of the objective to the perspective: Successfully Introduce Moonsnail Babycream Reduce Overhead & Operating Costs Increase Wholesale Business Increase Website & Catalogue Sales FINANCIAL Realise good profit margin from sales. Set overall cost reduction target based on desired retail price reduction. Set overall wholesale goal, as a percentage of total sales. Set sales goal, as a percentage of total sales. CUSTOMER Promotional effort to introduce product & features. Reduction in retail prices to reflect lower costs. Utilise sales by wholesale partners to further promote products. Utilise means to make ordering Moonsnail products more convenient. INTERNAL PROCESSES Streamline & clearly define product-related activities. Utilise Activity-Based Costing method. Develop efficient ordering & production protocols to maintain product quality. Plan & update catalogues & website at same time as production planning. GROWTH & LEARNING Market & competitive product research. Communicate cost-reduction goals to staff and get their buy-in. Use feedback from wholesale customers to refine wholesale activities. Study & review Internet marketing & e-commerce methods. Fig. 7: Balanced Scorecard Part 1 Each of these sixteen (there would of course be more if additional goals are set) components must then be assigned a target, the activity to achieve the target must be defined, and the measure that defines the target must be described. If desired, the individual goals can be assigned priorities from highest to lowest. These can be then be arranged in the form of a second chart: Objective Target Activity Measure Realise good profit margin from sales of Moonsnail Babycream. 30% margin. Product pricing. Actual margin at year-end. Promotional effort to introduce Babycream product & features. $1,000 budgeted for promotion. Advertising. Total sales & margin at year-end. Streamline & clearly define product-related activities. Activity/cost driver list for each product. Observe & note activities. Lists on file by year-end. Market & competitive product research. In-house testing and/or customer feedback for all competitive products. Purchase & try products; obtain customer feedback. Reviews on file by year-end. Set overall cost reduction target based on desired retail price reduction. 20% reduction. Review material & overhead costs. 2001 year-end costs vs. 2000 year-end costs. Reduction in retail prices to reflect lower costs. 20% reduction. Re-price products based on cost analysis. Actual retail prices. Utilise Activity-Based Costing method. ABC done for each product. Calculate cost drivers. Analyses incl. in year-end records. Communicate cost-reduction goals to staff & get their buy-in. 20% cost reduction. Team meeting(s); cost-saving feedback from staff. 2001 year-end costs vs. 2000 year-end costs. Set overall wholesale goal, as a percentage of total sales. 10% of total sales. Acquire wholesale accounts. Sales results at year-end. Utilise sales by wholesale partners to further promote products. 5% of retail sales from customers who bought at wholesale store. Co-op advertising; website/contact info incl. with products. Sales results at year-end. Develop efficient ordering & production protocols to maintain product quality. Zero amount of product written-off. Work with wholesale accts. to produce/ship appropriate quantities. Volume of product shipped not to exceed shelf life. Use feedback from wholesale customers to refine wholesale activities. No missed orders or over-ship quantities. Work with wholesale accts. to produce/ship appropriate quantities. Good feedback; wholesale goal met. Set catalogue/Internet sales goal, as a percentage of total sales. 10% of total sales. Maintain up-to-date catalogues & website. Sales results at year-end. Utilise means to make ordering Moonsnail products more convenient. 10% of total sales from catalogue/Internet. Offer credit card/Paypal & phone order services. Sales results at year-end. Plan catalogues/website at same time as production planning. No out-of-date information. Match catalogue/website pricing & info with forecasts. Unscheduled revisions not needed. Study Internet marketing & e-commerce methods. One good new idea every month. Use Internet resources; seminars/webinars. Internet sales goal met. Fig. 8: Balanced Scorecard Part 2 To be fair, the specific goals of sales percentages or cost and price reduction percentages are a bit arbitrary; these can only be decided after the proper cost analyses with the necessary complete information are conducted. After that, however, at any point during the year the company’s activities can be checked against the targets to see if they will be reached. Analysis of the Year 2000 Statement & Balance Sheet and Underlying Assumptions The projected 2000 budget assumes a 50% increase in retail sales with a corresponding increase in the cost of goods sold. The flaw in this assumption, however, is that no allowance is made for inflation, and this seems unrealistic as far as materials are concerned. Assuming a 2% p.a. rate of inflation – the same rate which is applied to the investment analysis of the Lunenberg Soap Company in the section below – the adjusted cost of goods sold becomes $18,606, reducing operating profit to $44,967. This is a small change, certainly, but one that should be noted for the sake of accuracy. What is not clear is if the projected revenues reflect the introduction of Moonsnail Babycream or not. If they do, then the projected retail revenue only reflects an increase of 29% among all other products and the wholesale revenue is entirely inaccurate, since the projected wholesale revenue from Babycream alone would be $25,200. The actual cost of goods sold would also increase by $9,100. All other things being equal – except for the need to account for inflation – correcting for the projected wholesale revenue including Babycream and updating the cost of goods sold yields a total revenue of $123,864, cost of goods sold of $27,706, and an operating profit of $58,067, quite a bit more positive than the initial budget projections. To improve the effectiveness of the budget in general and its use as a performance management tool, two versions should initially be produced, one including Babycream and one without; this would further help assess whether introducing the new product is advantageous. And of course, the only way to assess whether the budget is practical is to review it on the basis of past performance on a monthly or at least a quarterly schedule to examine variances. In that sense, the best way to approach using a budget as a performance indicator is to shorten the period of the budget; either use a yearly budget which is continuously updated, or a budget which is only applicable for the short-term future. Investment Analysis: Lunenberg Soap Company With the initial information provided, the Net Present Value method is used to assess the attractiveness of purchasing the Lunenberg Soap Company. This method of assessment, however, makes several assumptions. First, the estimated sales volume for Lunenberg products is assumed to be accurate, and for the soap products, is assumed to be equally divided between the two varieties, at an average retail price of $7.45/unit. Second, the assumption is made there is no other cash inflow for the company apart from sales of products, nor outflow apart from the variable costs and overhead. Third, the 2% p.a. expected inflation rate will be applied to the overhead costs, but they will otherwise be assumed to remain constant. Fourth, the calculation will be based on the known offer price of $130,000. Finally, retail prices will be assumed to remain constant throughout the four years of the analysis. In order to make this analysis more accurate, the following information should be provided: Accurate cash-flow information. The applicable tax rate. The depreciation rate on any equipment that will have to be purchased. This information is a necessary part of a proper assessment based on the Net Present Value method, and examples used to illustrate the method invariably include it. (Northcott & Alkaraan, 2007) Since this is only an initial analysis, the given information should provide a sufficient basis for determining whether a more detailed analysis will be worthwhile. Year Var. Costs Overhead Revenue Cashflow Discount Rate Discounted Cashflow 0 ($19,480) ($41,155) $67,100 ($160,245) ($160,245) 1 ($25,830) ($31,895) $87,230 $29,505 .909 $26,820 2 ($34,251) ($32,533) $113,399 $46,615 .826 $38,504 3 ($41,923) ($33,183) $136,079 $60,973 .751 $45,790 4 ($51,315) ($33,846) $163,297 $78,136 .683 $53,367 NPV $4,236 Fig. 9: NPV Analysis of Lunenberg Soap Company This analysis does result in a positive NPV, but not a particularly impressive one; it suggests that the maximum bid for Lunenberg Soap Company should be no more than $134,000. Given the number of assumptions that have to be made for this basic analysis and the amount of missing information, there is a high probability that the NPV would be revised downward under a more exacting analysis. Therefore, it is not recommended that the purchase of Lunenberg be considered, since the known existing bid is very near or possibly higher than the reasonable price for the company. References CIMA (2001) ‘The Balanced Scorecard – An overview’ [on-line] CIMA Technical Briefing. London: CIMA. Retrieved from: http://www.cimaglobal.com [Accessed 11 April 2010]. Collier, Paul M. (2006) Accounting for Managers. 2nd Edition. Chichester: Wiley. Evans, Matt H. (2002) ‘Course 11: The Balanced Scorecard’ [on-line] Excellence in Financial Management online course module. Retrieved from: http://www.exinfm.com/training/pdfiles/course11r.pdf [Accessed 12 April 2010]. Majid, Jamaliah Abdul, and Sulaiman, Maliah. (2008) ‘Implementation of activity based costing in Malaysia: A case study of two companies’, Asian Review of Accounting, Vol. 16, No. 1, pp. 39-55. [on-line] Emerald. Retrieved from: http://assets.emeraldinsight.com/10.1108/13217340810872463 [Accessed 13 April 2010]. Northcott, Deryl, and Alkaraan, Fadi. (2007) ‘Strategic Investment Appraisal’ in Hopper, Trevor, Scapens, Robert, and Northcott, Deryl (Eds.) Issues in Management Accounting. 3rd Edition. London: FT Prentice Hall. Sims, Adrian. (2001) ‘A model approach’ [on-line] CIMA Insider. London: CIMA. Retrieved from: http://www.cimaglobal.com [Accessed 11 April 2010]. Weetman, Pauline. (2006) Financial and Management Accounting. 4th Edition. London: FT Prentice Hall. Read More