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Sippican Corp. (A) Case Solution
Sippican Corporation manufactured products used to build water purification equipment. The president, Robert Parker was concerned about the reduction in prices of pumps by the competitors. Under the existing method, valves and flow controllers were considered the most profitable products. However, the pre-tax margin of the firm fell to 2%. Using the activity-based costing method for overhead allocation, flow controllers appeared to cost a loss of 4% while the other two products had high-profit margins. Therefore, Sippican should decide a course of action to improve the profitability of flow controllers. However, demand forecasts are required for a better estimate of cost and profitability under the new method.
Following questions are answered in this case study solution
What is the competitive situation faced by Sippican?
Given some of the apparent problems with Sippican's cost accounting system, should executives abandon overhead assignment to products entirely by adopting a contribution margin approach in which manufacturing overhead is treated as a period expense? Why or why not?
How does Sippican’s existing cost system operate? Develop a diagram to show how costs flow from the factory cost accounts to products.
Develop and diagram an activity-based cost model using the information in the case. Provide your best estimates about the cost and profitability of Sippican’s three product lines. What difference does your cost assignment have on reported product costs and profitability? What causes any shifts in cost and profitability?
Based on your analysis for Question 4, what actions might Sippican’s management team consider improving the company’s profitability?
What concerns, if any, do you have with the cost estimates you prepared in the answer to Question4? What other information or analysis would you want for better cost and profitability estimates?
Sippican has been compensating salespersons with commissions on their gross sales volumes (fewer returns). Wonders whether the company should change this incentive system. What do you think?
Case Analysis for Sippican Corp. (A)
1. What is the competitive situation faced by Sippican?
Sippican produced three main products; valves, pumps, and flow controllers. Initially, Sippican’s uniquely designed valves were produced to tolerance better than the competitors. Due to these high-quality valves, Sippican was able to gain loyal customers. Later, Parker realized that labor and equipment could also be used to produce high-volume pumps and customized flow controllers. As their existing customers demanded these products, the production for these products started simultaneously.
For Sippican, the valve is the standard product. Currently, a lot of Sippican’s competitors are able to match Sippican’s valve quality. Sippican could, potentially, lose their customers. However, as the competitors are not cutting prices, Sippican is able to keep the margin of valves at a standard of 35%.
Sippican faces high competitive pressures for the high-volume pumps. This is because, each month, the competitors’ reduce prices. In order to retain its market share, Sippican also has to reduce the prices. Consequently, the margin has dropped dramatically from 35% to 5%. As this price war continues, the margin might reduce even further.
The flow controllers manufactured by the firm are customized. They are produced according to the specifications from customers. This product highly prices inelastic as the 10% rise in price did not affect the demand. This might be because only a few competitors supplying this product. Hence, the competitive pressure for flow controllers is the lowest.
2. Given some of the apparent problems with Sippican's cost accounting system, should executives abandon overhead assignments to products entirely by adopting a contribution margin approach in which manufacturing overhead is treated as a period expense? Why or why not?
Currently, Sippican is operating on a simple accounting system. Sippican allocated the material and labor cost directly to the product. For the factory overheads, the cost is allocated to the product at 185% of the production-run direct labor cost. The direct labor cost is recorded for the preparation of payrolls. This method is advantageous for the firm as it is inexpensive for the firm to implement it.
However, there are a lot of disadvantages to using this method. Firstly, as the factory overheads cost 35% of the revenue, a higher percentage than the material and labor cost, they have to be apportioned, carefully, to determine the true contribution of each product. As Sippican produces more than one product, the simple cost accounting system, using a single allocation base, would not be able to depict the actual profitability of each product. It is important to note that the three products are entirely different from one other based on their complexity and production requirements. For instance, flow controllers require more components and labor than valves and pumps. In this scenario, activity-based costing would be a more appropriate and accurate accounting system. This is because, in activity-based costing; different overheads are apportioned to different products based on their cost drivers. Once this system is implemented, the profitability of each product is known. This will facilitate Sippican in future decision making and resource allocation.
3. How does Sippican’s existing cost system operate? Develop a diagram to show how costs flow from the factory cost accounts to products.
The diagram in Exhibit 1 shows how the existing cost system operates at Sippican. The circles on the top represent the three products; valves, pumps, and flow controllers. The rectangle boxes represent the total cost of material, labor, and overheads. The arrows signify the cost drivers. For the Material cost, the cost driver is the material requirement of each product. Labor cost for each product is determined by the labor hours. The overhead allocated to each product is 185% of the labor cost of each product.
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