Ace Manufacturing Essay

Of all the topics in this course, many students find Lesson 4 to be the most frustrating. I think this may be due in part to an apparent contradiction: there are lots of numbers and equations to work with, but surprisingly little certainty in our conclusions. I share your frustrations at times. Fortunately, these cases are the only â€Å"strictly financial† case studies †¦ the only ones where number crunching is an end unto itself. However, basic financial analysis will always be an important part of our toolkit for making pricing decisions. The document which follows contains the â€Å"answers† to these two case study assignments: Ace Manufacturing and Healthy Spring Water. Despite the financial emphasis, they are similar to the previous cases insofar as they’re intentionally open-ended and somewhat vague to encourage you to draw out all of the contingencies and factors that need to be considered. They’re intended to stimulate thinking. If you feel a bit frustrated by that, it probably means they’re working. Only after you’ve identified the issues and concepts that are relevant to the questions can you start to focus your efforts on how to solve the problem. This is my answer key (of sorts) for the two assigned cases. I know  how much many of you struggled with this case and your efforts were not in vain. Having had to slog through all of the confounding complexities of financial analysis is necessary to fully prepared you for what may lie ahead in your professional endeavors. Ace Manufacturing 1. What is the relevant unit cost for making this pricing decision? There are two primary alternatives that you might consider when approaching this question. Those of you who have this type of responsibility in a â€Å"real world† context are likely to suggest that fixed costs and G&A costs should be allocated equally/proportionately across the two products. At the opposite extreme, you might have chosen to argue that the additional 30,000 units should only be required to cover the incremental costs incurred †¦ implying a relevant unit cost of $7.50. Is one of these approaches â€Å"better† or â€Å"more correct† than the other? Is one of them more realistic? More conservative? Is one approach more conventional †¦ and does being â€Å"conventional† mean it is correct? Arguing persuasively for either position †¦ or a compromise view in between the two †¦ has some merit. And †¦ I’ll certainly try to be fair in evaluating your work, but I have a bias toward being both conservative and coldly realistic. Here’s my thinking †¦ building the units requires using designs that cost money to build and tooling that the company borrowed money to purchase. These are direct fixed costs. They also require maintenance of the plant which is currently being covered by the first 150,000 units. Since incurring these costs is necessary to producing the additional 30,000 units, why shouldn’t the additional 30,000 units be required to cover a fair share of the costs? That leaves the $60,000 increase in General and Administrative Costs associated with the new production †¦ which I would treat in the same way as the increases in direct fixed costs. Does all of this â€Å"squabbling† about how and where to allocate costs make a difference? It makes a big difference in evaluating the profitability of pursuing this new account. 2. Is this business sufficiently profitable to make bidding worthwhile? Although there can be a few subtle variations on this analysis, here’s the way that the two alternative approaches to allocating costs break down: One approach (Plan A) yields a profitable outcome †¦ $2.50 per incremental unit. The other, a loss of $1.25 per incremental unit. When you look at the total dollars columns, however †¦ either scheme generates the same level of profitability – a net gain of $75,000. Confused? The notion of the incremental units covering their â€Å"fair share† of fixed costs shows a net loss resulting from this additional business, but you can’t argue with the total dollars outcome. While the additional units don’t cover their â€Å"fair share† of costs, they contribute $75,000 toward these costs – costs that would not have been covered by the original 150,000 units. In this situation, the concepts of fairness and conventional practice could obscure a profitable opportunity. Based on the financial analysis alone, the company should definitely take the new business. What other considerations are relevant? Well †¦ is there a potential downside in terms of â€Å"indirect† cannibalization and price erosion? There’s always the Walmart effect to worry about †¦ that if you sell an â€Å"incremental volume† of goods at a discount through an alternative channel, buyers may switch channels – and 10,000 units sold at discount will cannibalize 10,000 units in sales at higher margins. Another concern is that prospective buyers will use the lower-priced â€Å"inferior† product as leverage in negotiating the price of the better product. Even slight price reductions in the 150,000 of regular sales would wipe out any profitability gains from additional sales of the inferior product. A simple case study †¦ and two short questions. But appearances can be deceiving. For grading purposes, I’m looking for a thoughtful analysis of the situation †¦ a recognition that there’s more here than crunching a few numbers. A â€Å"bad answer† would be one that rejects the possibility of pursuing this account without recognizing that it is a profitable venture from a strictly financial perspective.