berkshire a

Colin Drury, Management and Cost Accounting Berkshire Threaded Fasteners Company

Berkshire Threaded Fasteners CompanyTeaching note

Professor John, The Amos Tuck School of Business Administration DartmouthCollege

Overview

This case is an updated version of one which goes back at least as far as the 1950s, written byProfessor J. P. Culliton of Harvard Business School. It exists today in many versions under manynames. Its durability results from its usefulness, early in a Management Accounting course, toreinforce the concepts of "profit contribution" and "relevant cost analysis" while still showing theusefulness of full absorption costing. The controversies in the case - full cost versus marginal cost -are timeless. They are just as relevant today in training "wise" managers as they were forty years ago.The case was originally set in the mid 1970's. The years have been updated to relate to the late1990's and early 2000. The quantities and prices have not been updated from the 1970's.

Teaching strategy

We use the case on day 2 of the required managerial accounting course. Our students already havehad a heavy dose of "marginal cost" logic from earlier courses in economics, marketing, and finance.We don't have to spend much time teaching relevant cost mechanics. Rather, our challenge is helpingstudent see how to use marginal cost and full cost information intelligently. We teach the case bygoing through the four questions in the case, one at a time as shown below.

We present first the calculations for the first three questions and some additional comments which aredesigned to help students see the richness of these issues.

QUESTION 1: Drop 300 as of 1/1/00?

Volume = 501,276 units of 100 items eachCM/100 = $1.15 (2.70 - 1.55)CM = ~ $576,000 rounded or, more precisely, $1,355 - $773 = $582

Profit now $70 $70

Lost CM ($576) ($582)

Loss ($506) ($512)

An alternative format to show the same result is:

Std. profit on 100 138

Std. loss on 200 (103)

Fixed costs from 300 (693)

(still incurred)

+ the variances * (favorable) 146

(512)

* This assumes there is no volume effect in these variances, the bulk of which come fromoverabsorption of fixed costs due to the volume increase in 2000.


Other Issues For Discussion in Conjunction with Question 1

Define variable cost. The following table (TC-1) is a useful summary.

TC-1Berkshire FastenersContribution Margin by Product

Per Unit #100 #200 #300

List Price $2.45 $2.58 $2.75

Net Price $2.42 $2.52 $2.70

"Variable" Costs

Factory Labor $ .61 $ .59 $ .70

Raw Materials .63 .75 .81

Power .01 .02 .03

Repairs .01 .01 .01

Total $1.26 $1.37 $1.55

"CM" $1.16 $1.15 $1.15

Allocated Fixed Expenses 1.02 1.29 1.38

"Profit" $ .14 ($ .14) ($ .23)

Define fixed cost. What does it mean when the accountant states the cost is fixed?

Should labor be considered variable? In many foreign countries and many leading U.S. firms(IBM, Hallmark, DEC) this cost is considered fixed. When labor is treated as "variable" cost,the behavioral implications regarding motivation and commitment can be serious managementproblems.

Given the incremental analysis above, would it make sense to drop product 300?

Note that the solution to Question 1 is very dependent on your classification of cost. If in thelong run all costs are variable, then this product line is a long-run loser.

Would you want all your products to have the same characteristics as the 300 line?

If students say they would not want all their products to have the same characteristics as the300 line but they would not drop the product line, then ask what the day looks like when theywould drop the 300 line. In other words, when (specifically) does the long-run start?

Is the problem insufficient volume? Can you reasonably expect to get more? [A commodityproduct in a down market and in an industry in long-term decline.]

Management Inferences Regarding The Decision To Drop 300

1. The firm would incur a loss of $512K instead of a small profit of $70K if product line 300 weredropped.

2. But product 300 is a loser on a full-cost basis.

3. If only contribution analysis is used, a company will never drop any product since it is rare fora product not to cover its variable costs.


4. What should be done when a once successful product stops covering its full costs, as product300 has? One possibility: develop a product with a higher margin that will use the same assetsand can be priced in excess of its full costs.

5. When (what will be the characteristics of the specific day) do you decide to take actionregarding a product line that is "OK" on a short-term basis but "terrible" on a long-term basis?The problem here is that the "right" answer in the short run is the "wrong" answer for the longrun. When does the long run start, if not now?

The "contribution format" earnings statement (Table TC-2) can be used to focus students' attention onthe fixed/variable cost distinction.

TC-2Berkshire 1999Earning Statement - "Contribution Format"

#100 #200 #300 Total

Units (100) 2,132K 1,030K 987K

CM/100 $1.16 $1.15 $1.15

CM $(000) $2,494 $1,174 $1,145 $4,813

"Fixed" Costs

Rent $530

Factory Overhead 360

Selling 1,839

Administration 653

Depreciation 1,359

Interest 145

4,886

Loss (73)

"Allocated" Fixed Cost $2,199 $1,323 $1,364

"Fully Absorbed" Profit $295 ($149) ($219)

QUESTION 2

Here is the conventional relevant cost analysis for the pricing choice:

Pricing Decision

Price $2.45 $2.25

Less Cash Discount .03 .03

Net Revenue $2.42 $2.22

Less Variable Costs 1.26 1.26

Unit Contribution Margin $1.16 $ .96

Volume 750,000 (2) 1,000,000 (1)

Total Contribution $ $870,000 $960,000

1. This represents holding on to current volume levels. How likely is this when the overall marketis weakening and we are matching industry price?


2. This represents holding on to 75% of current volume in a weakening market (for a commodityproduct) while charging 10% above market price. How plausible is this? Is this a long-run orshort-run view?

3. Will the fixed costs be the same across these two production levels?

Management Inferences Regarding the Pricing Decision

1. Berkshire sells a commodity product in an industry where several of its competitors are muchlarger. Bosworth, the dominant company, has announced a price reduction on product line100. Berkshire has no alternative but to meet Bosworth's price. The choice is to match thenew price or exit the business. We do not need any financial analysis to reach this conclusion.

2. However, financial analysis can point out that product line 100, on a full-cost basis, is a bigloser? Thus, the low price (which Berkshire is forced to meet) is hardly a viable option for thecompany in the future.

3. When do we take some substantial action about positioning or cost for this product?

4. The contribution margin approach to this question provides a rationale for cutting the price.This can be interpreted as saying that the lower price is "more profitable". Actually, the lowerprice is not viable, long run, although it results in a lower loss! Is contribution margin thinkinghelpful here? Or, is it a trap which camouflages the long run loss position?

a) A CM perspective suggest higher volume can compensate for lower margin per unit:

Price 2.42 2.22CM 1.16 .96

CVP for Volume?

(Can I get enough more volume at the $.96CM/unit to compensate in total CM dollars?)

b) A full cost perspective suggests more clearly that volume cannot compensate for a"losing" price:

Profit .14 (.06)CVP is easy!

(No volume level can make a losing price equally profitable with a profitable price!)

We present here a digression on full cost versus variable cost for decision making. This can be usedby the instructor at any time during the class to reinforce the basic logic of "contribution analysis" andto challenge its usefulness.

The "Managerial" view on "Fixed" Costs

One view:

Incorporating fixed costs while making decisions is clearly suspect because:

The resulting per-unit amount is only accurate at one particular volume level.

It may confuse people by making a fixed cost appear to be a variable cost.

It involves arbitrary allocation rules which cannot be justified/verified.


It distorts C-V-P relationships.

Economic theory suggests that fixed costs are irrelevant for short-run decisions.

Counterview

Economic theory suggests that fixed costs are relevant in the long run.

Many decisions are more long run than short run (there are very few pure short-run decisions)

Fixed costs must be covered by the products in aggregate, so why not charge each productfor a "fair" share?

Whereas "full cost" distorts the short-run perspective, "incremental cost" distorts the long-runview... Which is a bigger sin?

Business history reveals as many sins by taking an incremental view as by taking a full-costview (consider the "Braniff" Fallacy!).

The "Braniff Fallacy"

Full fare from Dallas to New York? Full cost + return on investment = $300 "Incremental" cost = $.79 (for the extra "meal" (sic)) If charge $50, to fill up the airplane, contribution per passenger = $49.21 There will be a contribution, but no profit!

Are the fixed costs "Relevant for Decision Making Regarding Pricing?"

In Cost Driven Business(The seller is a pure price taker.)

Cost is clearly irrelevant for pricing.But, Price < Full Cost says: Exit the business or cut cost.

In "Imperfect" Competition

(Far and away the more typical situation. All players offer a somewhat unique blend of ProductFeatures/Availability/Terms/Quality/Service/Image/...)

"Fixed Expenses" represent, ex ante, attempts to create "monopoly rents."They thus represent a going-in proxy for anticipated value to the customer.If a firm does not attempt to price for them, the firm is disavowing the ex ante differentiation strategy!

QUESTION 3: Which is Berkshire's most profitable product?

Some Possible Measures of Profitability #100 #200 #3001. PBT - Full Cost Basis (Ex. 2) $295 (149) (219)2. PBT/Unit - Full Cost Basis (Ex. 2) .14 (.14) (.23)3. Contribution:

Total $ 2,494 1,174 1,145As % of sales revenue 48% 45% 43%Per Unit 1.16 1.15 1.15


4. Assume Labor is the scarce resource. The idea here is CM per unit of scarce resource.

Contribution per DL Hour

$4.20/DLH LH/unit CM/LH per unit

#100 .61/4.20 = .145238 $1.16/.145238 7.99

#200 .59/4.20 = .140476 $1.15/.140476 8.18

#300 .70/4.20 = 166667 $1.15/.166667 6.90

5. Contribution per machine hour?

6. Value added:

Sales Price - (Raw Material + Power) .78 1.75 1.86

7. Other Measures...?

[Note: Each of the 3 products excels on at least one measure.]

WHICH IS MOST PROFITABLE?? IT DEPENDS!!

Here, none is a "best" product!

Can we tell how the company has allocated the fixed expenses for purposes of measuring full costprofit? What rule(s) have they used?

Fixed Overhead Allocations - 1999 (percent of total)

Product Volumes 100 200 300

Sales ($) 49.5% 24.9% 25.6%

Sales (Units) 51.4% 24.8% 23.8%

The Overall Allocation % 45.1% 27.0% 27.9%

Individual Overhead Items

Selling 49.5% 24.9% 25.6%


5. None of the products looks like a real winner, in the long run. That is, from a broad managerialcontext, Berkshire has no "most profitable product". All three products are dogs!

We turn now to Question 4, which is broader, asking the students to offer advice to the owner of thecompany about management issues. This question is designed to make students think aboutmanagement issues even when no specific area is highlighted for them. This part of the mission of theTuck school, to train future general managers, even in "tool" courses such as managerial accounting.We find that students like to struggle with broad "whither the company" questions, given a littleprodding. We believe it is useful to consider the role of financial analysis for strategic questions, toreinforce the broad relevance of accounting to management.

Current Conditions at Berkshire

1. Berkshire is currently earning very poor returns as a business (pretax ROA of only ~ 1%,annualized, for 2000). What should they do?It is possible for students to estimate a balance sheet for the business as of 2000 (seeattached Table TC-3).This is necessary to estimate ROA or ROE. We do not assign this on day 2 of the course,but we do illustrate it in class to show students that it isn't really difficult. We want toencourage them to try to estimate the owners' investment in a business, wheneverpossible, as a broad backdrop for considering management issues.

2. Profit contribution is more than 40% of the sales price for all three products, which is notbad, for industrial "commodity" products.

3. But, fixed costs as % of sales (47%) is very high for a manufacturer of undifferentiatedindustrial products.Particularly, selling cost at 17+% of sales is very high for an industrial "commodities" firm.Also, depreciation at 13% of sales seems very high for a firm for which direct labor is still25% of sales.

4. The high direct labor cost (25% of sales) in the face of also high depreciation cost (13% ofsales) suggests that we have not reduced labor as we bought additional machines and asvolume has weakened. This may mean a labor policy of holding on to the machinists andtool makers in spite of tough times. This may mean we have a loyal and highly skilledwork force as a strategic strength.

5. The overall suggestion here is that Berkshire is geared up for much more volume than it isachieving. They are running well below sales and manufacturing capacity, even in a"good" business year (1999). But they are not likely to see much, if any, volume growth.They are in a declining market situation (metal fasteners manufacturers in New England atthe end of the "good years" - 1946 to 1970, based on the original case setting of the mid1970's)

6. The key strategic assets for Berkshire include an apparently very well paid sales force, aflexible set of fairly new machine tools, and, possibly, a dedicated cadre of skilledmachinists and tool makers. Is it possible for Berkshire to use these key strengths todevelop and market a set of new products (that will replace 100, 200, 300)?

TC-3An Approximate Balance Sheet

ASSETS LIABILITIES & OWNERS' EQUITY

Cash $ 0.9M Current Liabilities $ 1.9M

Accounts Receivables 1.3M


Inventory 1.6M Long Term Debt 2.4M

Equipment - Cost* 27.2M

Accumulated Depr'n* (13.6M) 13.6M Equity 13.1M

Total $17.4M Total $17.4M

Assumptions

CASH - only a minimal amount kept on hand. One month's revenue is equal to about $.9M.

ACCOUNTS RECEIVABLE - 45 days sales revenue would be about average for an industrial firm.

INVENTORY - assumes 4 inventory turns per year 6511/4 = ~ $1.6M. Three to four inventory "turns"was "normal" for a manufacturing company in the days before "JIT".

*EQUIPMENT COST - this is 20 times the yearly depreciation expense, per case Exhibit 3.

ACCUMULATED DEPRECIATION - assumes that equipment is 1/2 depreciated, on average.

"Older" "Newer" 13.6 13.6 (10.0) (3.6) 3.6 10.0

CURRENT LIABILITIES - assumes a 2:1 current ratio, which would be about average.

LONG TERM DEBT - calculated from the interest expense, using a 6% interest rate as shown inExhibit 3 of the case.

EQUITY is a plug, given the other assumptions.

The Strategic Position?

Berkshire does not achieve product differentiation.

Berkshire does not achieve low cost leadership.

Me Too/Mir Auch/Moi Aussi

Berkshire is "stuck in the middle" in a seriously declining industry.

Given this assessment of the current position of Berkshire, what choices do they have? The followinglist (Table TC-4) shows some of their options. We don't plan to spend much time on this list or to pushvery hard for a firm "solution", but we believe it is useful to provide this kind of context at the end of theclass. Taking a narrow perspective on questions 1, 2, and 3 using "relevant cost analysis" just doesnot capture the richness of the management dilemma in this case.

In summary, we think this is an excellent case near the beginning of the course. It provides goodreinforcement on basic cost analysis concepts for add/drop, product emphasis, and competitivepricing. But it also shows these concepts in the context of a much richer management setting whichcan be used to illustrate a broader vision of the role of managerial cost analysis.

TC-4BERKSHIRE FASTENERS - BASIC STRATEGIC OPTIONS

I. Change the Product MixBut, note that no "mix" of 3 losing products can gain real success.


II. Cost Reduction (Retrench?)But note that a small player like Berkshire is never likely to win the "cost leadership" battle.

III. "SWOT" Analysis might imply trying to become a "Contract Manufacturing" Shop

IV. We have good machines, workers, and sales people but poor products. Can we sell ourmanufacturing capability to firms who are willing to "buy" manufacturing?

V. New Products- Evaluate key strengths we could use for new products- Find niches that play to our strengths

VI. Sell the Company Quick!!To whom? Why?What will they do with it?Does Bosworth need extra capacity? (Unlikely). Is there really any "going concern" value(goodwill) for Berkshire?

VII. Hunker Down & Hope"Rationalize "do nothing" by more study!

Based on the original case setting of the mid 1970's, there were more than 100 threadedfasteners (nuts and bolts) manufacturers in the U.S in 1960. Only one U.S. manufacturer wasleft in 1985. The situation over the years can be represented on a Porter style "growth/sharematrix." The figures in the parenthesis represent a restatement to reflect the updated yearsused in the case.

Market Growth/Share Matrix

High

Low Low High

RELATIVE MARKET SHARE

"Build" "Hold"

"Divest" "Harvest"

Berkshire1964

Berkshire1974

1 2

43

Berkshire1980?

berkshire a

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