Question

Polly Peyrotte started designing and decorating fine china plates more than 100 years ago. As her artistry caught on, she became famous. She also turned out to have considerable business skills. She grew her design studio into what today is Polly Plates, Inc. (PPI), with $36 million in annual revenue. Polly’s daughters and granddaughters became involved in the business after Polly’s retirement and hired talented designers who could carry on Polly’s tradition of beautiful plates.

In recent years, however, fewer family members have gone to work in the family business and professional managers hired from outside the family are now running most parts of the operation and serve on the board of directors. The few family members who remain on the board have become concerned about the business’ profitability and potential for future growth. They worry, for example, that the delicate flowers and landscapes that were a mainstay of the company’s designs decades ago no longer appeal to today’s collectors. Anna Slevnik, vice president of marketing and one of the last remaining descendants of Polly actively involved in running the company, defended the designs at a recent board meeting. Anna noted that many of the plates feature acanthus leaves, “…which have been adorning the world’s best architecture and most beautifully illuminated manuscripts for more than two millennia!”

At the 20x0 year-end board meeting (held in February of 20x1), the company’s controller, Robin Aul, reported that in calendar 20x0, PPI sold 15 million plates at an average price of $2/plate. The plates have variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead) of $0.50/plate.

The company has a substantial fixed manufacturing overhead cost of $20 million per year. Much of this overhead is rent paid to various Peyrotte family members who have inherited, as personal assets, the real estate (land and buildings) in which the company manufactures and warehouses plates. Gareth Snyder, a noted tax lawyer who was a trusted advisor to Polly in the early days of the company, often preached, “hold depreciating assets in the company, but hold appreciating assets in your personal portfolio.”

The good news about PPI’s high fixed manufacturing costs is that they provide enough capacity to make 60 million plates a year (which could come in handy if demand ever returns to the high levels of years ago). The company also has selling and administrative costs (all fixed) of $4 million per year.

Robin noted that the 20x0 beginning and ending inventories of plates were both zero and suggested that the firm might be losing sales and should consider keeping more plates in inventory to meet sudden increases in demand. Anna responded, “I believe controllers should stick to bean counting and leave important sales and distribution decisions to those who are experienced in such matters.”

The company’s president, Barbara Boxtuttle, had hired consultant Deb Bett in October 20x0 when she learned the company was likely to show a net loss for that year. Deb had given Barbara a copy of her report earlier in the day (of the board meeting)… and Barbara was not happy about it. Deb had concluded the report with a recommendation that the company replace Barbara with a new president. Deb’s report also recommended hiring Deb herself as a temporary president to turn the place around.

Deb, discussing her report at the board meeting, said her analysis showed strong evidence that PPI’s customer base was dying off and that the company needed new markets. Over Anna’s groans, Deb said, “In addition to the lovely plates the company has been selling for a century, we can open an exciting new market by printing funny sayings, slogans, and political messages on the plates. To do this, we must open new marketing channels, ramp up production to fill those channels, and spend more on advertising as we move into new markets.” Every time Deb said “we,” Barbara winced.

A lively discussion among the board members ensued, ending with a motion, duly seconded, to adopt the report’s recommendation. The motion passed, after which the board thanked Barbara for her years of devoted service and promptly fired her. The board then voted to elect Deb president for no more than two years and charged her with implementing the company’s new strategy.

To show her confidence, Deb agreed to a one-year contract that could be renewed for one-year at PPI’s option, but only if PPT showed a profit at the end of 20x1. Deb also agreed to an annual salary of $1 plus a bonus of 20% of annual net income. No profits, no bonus. Robin (the controller) made sure Deb’s employment contract included a provision that “net income,” for purposes of the contract renewal option and the bonus calculation, must be calculated using absorption costing, noting that, “Absorption costing is GAAP and that’s what our auditors will expect to see in a contract like this.”

In 20x1, Deb implemented her plan. She hired new staff to write the funny sayings, slogans and political messages to go on the plates, launched three separate advertising campaigns and trained PPI salespeople to call on the types of customers who would be interested in the new plate designs. As promised, she ramped up production and PPI manufactured 45 million plates in 20x1 and sold 18 million of them, a 20% increase in sales over 20x0. Deb was thrilled with the sales growth and was happy to have a huge inventory of plates at the end of 20x1. She believed that fresh orders would soak up that inventory as soon as the new selling channels opened up.

Doing all this was expensive. The new fixed selling and administrative costs (including Barbara’s severance package and Deb’s $1 salary) were $4 million, which doubled 20x0’s fixed selling and administrative costs to a total of $8 million for 20x1. Since manufacturing capacity is so far above current sales and production levels, fixed manufacturing overhead costs did not go up at all in 20x1. Deb also held variable costs per plate and the plates’ average selling price the same in 20x1.

At the year-end board meeting for 20x1 (held in February 20x2), everyone was jubilant over the sharp rise in sales and the excellent financial results. Robin (the controller) provided a draft income statement (absorption basis, of course) that showed a net income of $11 million (before taxes and Deb’s bonus). Celebratory champagne and caviar were served. The controller handed Deb a check for $2.2 million and the entire board gave her a standing ovation while chanting, “One more year, one more year!”

After thanking the board for the opportunity to show “what a little fresh thinking could do for a company that had been stuck in the past” (and for the $2.2 million), Deb announced her regret that she would be unable to continue for a second year. She explained that instead she would be on the next flight to Frostbite Falls, Minnesota, where Kernel Mills, a struggling cereal manufacturer, has asked her to help them turn around one of their businesses.

Requirements:

1. One of the board members, hearing of the net loss expected for 20x0 at the first board meeting described above, asked whether anyone knew how many plates the company would need to sell to break even. Calculate PPI’s breakeven point (in plates) using 20x0’s cost structure. Recall that a company’s cost structure is its selling price per unit, variable cost per unit, and total fixed cost.
   
2. Another board member at the 20x0 meeting responded to that query, asking, “Who cares what it takes to make zero net income? I’d like to know what sales would be necessary to make $2 million a year… as we did in the old days! Harrumph!” Calculate the sales (in plates) PPI needed to yield a net income of $2 million, using 20x0’s cost structure.
   
3. As the discussion about breakeven points and profit planning wound down, an elderly board member awoke from his nap, saw the breakeven charts on the projection screen, and mumbled something about “direct costing.” His granddaughter (also on the board and a recent business school graduate) responded by saying, “Wait! I think I remember that term. Yes, in fact, you can do a whole income statement using direct costing. In Professor Blatterfitzel’s class, we called it ‘variable costing’ or the ‘contribution margin format income statement,’ or something like that.” Prepare an income statement in reasonably good form for PPI’s 20x0 year using variable costing (also called “direct costing” or “the contribution margin format”).
   
4. Prepare a GAAP (absorption costing format) income statement in reasonably good form for PPI’s 20x1 year (show the results just as the controller would have … before taxes and Deb’s bonus).
   
5. Prepare PPI’s 20x1 income statement in reasonably good form using variable costing (also called direct costing or contribution margin format costing). Show the net income before taxes and before Deb’s bonus so it is comparable to Robin’s absorption cost net income.
   
6. Provide a one-word rating of Deb’s performance using one of these three words: Outstanding, Acceptable, Terrible. Explain why you chose that particular word, in detail.

Answer 1