Question

Question:

Current situation

Patterson has remained profitable, but its return on investment has been declining. The number of new products introduced has fallen as has the number of improvements to existing products. Whereas the firm once manufactured over two hundred products classified into six product categories, the firm now manufactures less than one hundred products in four categories. Only twelve of the products have current annual sales volumes exceeding $1 million. Further, many of the firm's once unique products now face substantial competition. However, the firm still has excellent relations with its employees. Although the union is strong, its primary focus has been on maintaining the firm's attractive wages and benefits. The union has been very flexible in allowing changes in duties and work rules to accommodate changing market needs. This flexibility has been one of the reasons Patterson has manufactured all of its products locally.

Columbia's CEO recently asked Patterson Manufacturing to seek ways to improve Patterson's profitability. Patterson's manager, in turn, appointed a multi-disciplinary task force to explore the possibilities. The task force was instructed to consider the widest possible set of options: expansion, acquisitions, down sizing, diversification, implementing manufacturing efficiencies, relocating production ... "Whatever it takes!"

After several meetings the task force focussed on outsourcing Patterson's largest selling product. Sales of this product benefit from Patterson's reputation for high quality, but the team is aware that several competitors offer a similar product at a lower price. This competition has resulted in a slow, but steady decline in market share for nearly a decade. However this single product still accounts for nearly 30% of Patterson's total production volume and sales.

The task force believes that a reduction in the cost to produce the product, coupled with a lowered selling price would quickly recapture market share leading to increased profitability. They have sent a recommendation to Patterson's manager that this product be acquired at a lower cost from an off-shore firm.

Patterson's manager has some misgivings with the recommendation and has asked you to prepare an analysis of the viability of the task force's recommendation. You have just recently been hired by the company and are keen to make a good impression from your first significant task. You obtained last year's summary income statement given in Exhibit 1. The human resources department provided the summary given in Exhibit 2. It provides the number of employees working in each of several categories along with their average compensation.

A detailed study of the product under scrutiny reveals that sales of the product amounted to $27 million last year. The direct material costs associated with the product came to $14.3 million while overhead costs of $4.5 million were allocated to the product. In answer to a question, an accounting colleague indicated that only $2.9 million of the overhead would be avoided if the firm stops manufacturing the product. The remaining overhead costs are nearly all fixed and not subject to reduction in the near future. Direct selling costs for the product consist of an 8% commission paid to our sales representatives. In addition there is a $2 million advertising allowance devoted to promoting the product in trade magazines.

You have determined that if the product is outsourced, Patterson will reduce the number of administrative managers by three and administrative support staff by eight. In addition, 10 supervisors and 128 general production personnel will be let go. The firm will incur a one-time charge of $2.5 million for severance pay, pension contributions and the construction of receiving facilities for the outsourced product.

Several potential suppliers were asked to submit proposals for supplying the product. The proposals are all very similar and reflect only minor savings in material costs but they all envisage major savings in labour costs. The preferred supplier's proposal is given in Exhibit 3. It details the proposed price for supplying the product in the quantity sold last year. The supplier indicates that $2 million of the overhead and all of the "other" costs in the proposal are fixed costs. If Patterson changes the quantity of product it acquires, a new unit price will be calculated based on a 10% mark-up over total cost. In addition to the quoted selling price there will also be a cost to transport the product from the point of manufacture to Patterson's receiving facility. This cost will vary directly with the volume of products shipped. At last year's volume the transportation cost is expected to be $0.6 million.

As you gathered the information for your analysis, you discovered that the marketing manager is a vocal critic of the task force's recommendation. She is related to the Patterson family and has lived her entire life in the local community. "This proposed action would be a devastating blow to the community. Patterson Manufacturing has never reduced employment except by attrition. Wesley Patterson would not have approved this action. He loved this town and devoted his life to it. We must abandon this plan and turn our attention to alternate means of increasing profitability."

Exhibit 1: Summary Income Statement for Patterson Manufacturing

                                                                                                           $ (millions)

                                            Sales                                                   90.2

                                            Cost of Goods Sold                         74.3

                                            Gross Margin                                    15.9

                                            Administrative Costs                         1.2

                                            Selling Costs                                       9.2

                                             Operating Income                           5.5

All figures are in millions of dollars. Interest expenses and income taxes are only shown on Columbia's consolidated financial statements.

Exhibit 2: Current Distribution of Employees by Job Title

                Number                                                                                                    Average

                      Of                                                                                               Compensation

              Employees                                  Job Title                                       Per Employee

                                                                                                                                          $

                      10                Administrative Manager                              45,000

                      24                Administrative Staff                                                     32,000

                      30 Production Supervisor                                                 50,000

                    430               General Production Personnel                                 37,000

Exhibit 3: Off-Shore Supplier's Proposal

                                                                                                            $ (millions)

                                            Material Costs                                  12.7

                                            Labour Cost                                        1.8

                                            Overhead Costs                                2.7

                                            Other Costs                                         1.5

                                            Total Cost                                         18.7

                                            Profit Mark-Up (10%)                       1.9

                                             Invoice Price                                     20.6

All figures are in millions of dollars. The invoice price is quoted based on supplying last year's production volumes. The quoted price is FOB the manufacturing plant.

Required

1.     If the product is outsourced the task force recommends decreasing the product's selling price by 5% with the anticipation that unit sales volume will increase by 15%. Prepare an analysis which determines whether this outsourcing plan is financially viable.

15 Marks

Answer 1

Here it is advisble for the company to outsource the product because it is beneficial more than the manufacturing itself. Here there is a additional cost of $2.5 million which will impact its benefit in first year but this is one time cost means the benefit will company acheive is for longer period. Hence the outsourcing of product is advisable.