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    Phelps Industries

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    Dan Fowler, the new CEO of Phelps Industries, is preparing the annual operations plan. Phelps produces gears using only 60% of its production capacity. Dan explores using excess capacity to produce sprockets, a new product. The accountant, Patricia, calculates sprockets will lose money due to high fixed costs being allocated to both products. However, Dan notes something is wrong with the accounting, as sprockets should benefit from excess capacity. He questions how costs, like unused capacity, are allocated and whether sprockets will truly lose money.

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    Phelps Industries

    Uploaded by

    shik171294
    391 views6 pages
    Dan Fowler, the new CEO of Phelps Industries, is preparing the annual operations plan. Phelps produces gears using only 60% of its production capacity. Dan explores using excess capacity to produce sprockets, a new product. The accountant, Patricia, calculates sprockets will lose money due to high fixed costs being allocated to both products. However, Dan notes something is wrong with the accounting, as sprockets should benefit from excess capacity. He questions how costs, like unused capacity, are allocated and whether sprockets will truly lose money.

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    4. Phelps Industries

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    Dan Fowler, the new CEO of Phelps Industries, is preparing the annual operations plan. Phelps produces gears using only 60% of its production capacity. Dan explores using excess capacity to produce sprockets, a new product. The accountant, Patricia, calculates sprockets will lose money due to high fixed costs being allocated to both products. However, Dan notes something is wrong with the accounting, as sprockets should benefit from excess capacity. He questions how costs, like unused capacity, are allocated and whether sprockets will truly lose money.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    391 views6 pages

    Phelps Industries

    Uploaded by

    shik171294
    Dan Fowler, the new CEO of Phelps Industries, is preparing the annual operations plan. Phelps produces gears using only 60% of its production capacity. Dan explores using excess capacity to produce sprockets, a new product. The accountant, Patricia, calculates sprockets will lose money due to high fixed costs being allocated to both products. However, Dan notes something is wrong with the accounting, as sprockets should benefit from excess capacity. He questions how costs, like unused capacity, are allocated and whether sprockets will truly lose money.

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    Phelps Industries

    Dan Fowler, who had recently taken over as the CEO of Phelps Industries, was confronting his first major
    task: preparing an annual operations plan for the next year (fiscal year beginning January 2001). Phelps
    Industries is a small operation located on the outskirts of Cleveland, Ohio. Rick Phelps, a young
    entrepreneur, incorporated it in 1980 as a family business. Rick was not overly ambitious. He just wanted
    to have a steady and independent source of income, and wanted to provide some employment for people
    in his township. The company grew steadily and modestly over two decades, and was making decent
    profit. Faced by some recent health setbacks, Rick decided to hire Dan in November 2000 to manage the
    operations of the company.

    Phelps Industries produced just one product, gears, used as a component in heavy machine tools
    manufactured by two competing factories located close by. (The firm made many sizes of gears but let us
    use one representative product for this discussion.) The demand was steady and Rick had developed
    excellent reputation as a reliable vendor. Just before Dan joined the firm, Rick had put together an initial
    budget for next year, which did not look very different from the budgets of prior years. Exhibit 1 presents
    the budgeted income statement and Exhibit 2 presents relevant product, revenue and cost details.

    After familiarizing himself with the operations of the company, Dan immediately noticed that the
    company had considerable excess capacity in terms of machine time (Exhibit 3); the utilization was just
    60 percent. Puzzled by this, Dan called Tom Morton, the production supervisor into his office to get some
    answers. Tom was his usual blunt self. “Rick really did not want to do much more. He was just satisfied
    with what is going on. He never worried about having more capacity as long as we made money. We just
    bought machines as we needed them and sometimes, we bought more than we needed. It is hard to predict
    how much we might need. I told him we should make something else with the excess capacity but he
    would not listen to me!”

    Dan got in touch with his two major customers to see whether he can get them to buy more, but they
    declined. As he contemplated the path forward, the company’s sales executive, Sally Witherspoon, had an
    idea. She says, “Let us introduce sprockets as a new product. We can make this product in our current
    facility with some minor changes and modest additional outlay. In addition, there is a ready market for
    this product, as another machine tool manufacturer nearby is in dire need of this component.”

    Encouraged, Dan quickly summarized the resource requirements for introducing this new product
    (Exhibits 4). Rick was surprisingly amenable to the idea. To make sure the financials would work, he
    asked his accountant Patricia Conway to get him the numbers on the profitability of sprockets. Two days
    later, Patricia walked in to Rick’s office with not so good news. “This new product is not going to be
    good for us,” she said presenting him with her calculations (Exhibit 5). “We are going to lose money.”

    Of course, Dan was deeply disappointed. However, “Something isn’t quite right,” he thought. How could
    we make a loss on a product with so much excess capacity at hand?
    Questions

    1. Estimate the income if Phelps were to produce and sell 20,000 gears per year? Produces and sell
    25,000 gears per year? How should we group costs to improve our estimate? Ignore sprockets.
    2. Phelps is currently operating with significant excess capacity. How is the cost of capacity being
    accounted for now? How could we change the allocation to separately identify the cost of unused
    capacity and target it for managerial action?
    3. Do you agree with Patricia? What is your recommendation? Support your answer with appropriate
    calculations.
    Exhibit 1
    Budgeted Income Statement for 20011

    Number of units 15,000

    Sales Revenue $1,800,000


    COGS 1,123,750
    Gross Margin $ 676,250
    Sales and admin salaries 280,000
    Sales commissions 36,000
    Distribution costs 30,000
    Net income $ 330,250
    1
    Phelps Industries produces to order and inventories are negligible. Ignore taxes in all computations

    Exhibit 2
    Product cost report (on volume of 15,000 units)

    Price per unit $ 120.00


    Materials cost per unit 20.00
    Labor cost per unit 25.00
    Manufacturing overhead 29.92
    Total unit cost $ 74.92
    Gross margin per unit $ 45.08
    Exhibit 3A
    Annual Manufacturing Overhead Costs: Detail

    Machine depreciation $115,000


    Supervisor salary 80,000
    Factory salaries 60,000
    Factory maintenance 62,500
    1
    Property taxes and utilities 15,000
    Power to operate machines 56,250
    Oils and lubricants 60,000
    2
    Total $448,750
    1.
    $10,000 of the utility cost pertains to property taxes and other unavoidable expenses. An additional
    $5,000 is required to maintain even a minimal level of operations to produce gears.
    2.
    Phelps Industries allocates fixed manufacturing overhead based on machine hours. Each gear
    consumes 2 hours of machining time. Available capacity in terms of machine time = 50,000 machine
    hours.
    3.
    The power to operate machines is 15% of direct labor cost; oils and lubricants (indirect materials) are
    estimated at $2 per machine hour.

    Exhibit 3B
    Selling and Administrative Costs: Detail

    Sales staff salaries $80,000


    Distribution costs 30,000
    Sales commissions 36,000
    General administration 200,000
    Total $346,000
    1
    Sales commissions are 2% of revenue and distribution is related to the number of units transported.
    Exhibit 4
    Sprockets: Additional Outlay

    Sales and cost data Annual increase in manufacturing overhead costs1


    Price (per unit) $73.00 Supervisor salary $40,000
    Materials cost (per unit) 25.00 Jigs and fixtures 22,500
    Labor cost (per unit) 30.00 Utilities 5,000
    Labor hours per unit 2 Power etc. 54,000
    Machine hours per unit 1.5 Oils and lubricants 36,000
    1.
    Adding sprockets would require a supervisor assigned to that product alone. Other costs pertain to
    special jigs and fixtures needed for making sprockets.
    2.
    The increase in utilities, which is traceable to sprockets, will occur regardless of the actual production
    volume for sprockets.
    3.
    As in the case of gears, the power to operate machines is 15% of direct labor cost; oils and lubricants
    (indirect materials) are estimated at $2 per machine hour.
    1.
    Exhibit 5
    Sprockets: Accounting Analysis of Profitability (15,000 gears and 12,000 sprockets)

    Panel A
    Projected manufacturing Overhead Costs (Total)

    Machine depreciation $115,000


    Additional jigs and fixtures 22,500
    Supervisor salary 120,000
    Factory salaries 60,000
    Factory maintenance 62,500
    Rent and utilities 20,000
    Power to operate machines 110,250
    Oils and lubricants 96,000
    Total $606,250

    Panel B: Product Profitability Report (Revised for the addition of Sprockets)1

    Gears Sprockets
    Price (per unit) $120.00 Price (per unit) $73.00
    Materials 20.00 Materials 25.00
    Labor cost 25.00 Labor cost 30.00
    Overhead cost 25.26 Overhead cost 18.95
    Gross margin $49.74 Gross margin (0.95)

    1
    Patricia, the accountant, helpfully points out that the loss per unit above is before considering the cost of
    the sales commission and distribution costs (estimated at $3.46 per sprocket).

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