Bridgstone Industries

During the 1988/89 year, the consultants downgraded manifolds to Class III (from Class II), indicating that they should be outsourced. Describe, as precisely as you can, why you believe manifolds appeared less profitable in 1988/89 than in 1987/88. Be sure to describe how Bridgeton calculates costs (which largely determine the consultant's classification), and which accounting and operational decisions led to the downgrading.

Based on the evaluation of costing and accounting techniques used it is believed that the manifolds appeared to be less profitable in 1988-89 compared to 1987-88 primarily due to the following:

Ð'* A comparison of the net profit and total margin for the manifolds appears to be less during 1988-89 compared to the corresponding numbers from 1987-88. (Table 1) .

Table 1

Ð'* A further dig into the details reveal that for manifolds as well as other products , Bridgton was able to maintain an upward trend in terms of gross profit while net profit, started plunging maximum for manifolds compared to rest of the products. This is primarily due to

o All the products including manifolds during 1987-88 covered and contributed proportionately towards overhead costs (~435%), while during 1988-89 as muffler/exhausts and oil pans are outsourced (hence dropped from the product list) the overhead cost are spread over less number of products resulting Manifolds to have a larger share of overhead to be absorbed.

o The costs corresponding to the redistribution of personnel into other departments and outsourcing cost spiked the overhead costs to rise from a rate of ~434% to 576%. Due to the absence of selling price per unit, it appeared that the aggregate net profit of the products (including manifolds) increased (as a % of sales revenue) while the net profit for manifolds (as a % of sales) are much reduced (14.01% in 1988-89 compared to 23.06% in 1987-88).

o Manifolds contributed maximum sales ($89,323) and direct labor cost ($6278) once muffler/exhausts and oil pans are outsourced. As a result, the overhead contribution (being proportionate to labor cost) for manifolds became the maximum, while reducing the net profit.

.As a whole the company has three major problems due to the current method of overhead allocations:

Ð'* The company falls into a classic case of "death spiral" with overall profits going up, and net revenue as well as profits going down, due to increasing overhead costs.

Ð'* The cost drivers (typically the direct labor costs) are no more relevant and no more represent a fair estimation of the resource usages. It is clear that after 1987-88 many changes have happened to the industry and market place (e.g. several program resulting to improve product quality and productivity). It seems due to increased automation and engagement of machineries, effectively reduced the significance of direct labor to remain as a major cross driver.

Ð'* Finally, the use of one cost pool to estimate the overhead costs for a wide variety of products with variation of usage of machinery, fixtures, direct labor and unskilled personnel to manufacture introduced confusion to distinguish the profitability of each of the products. The absence of data representing the number of units of production, added more confusion.

Cost Drivers: Bridgton used direct labor costs for each product as a % of total labor cost as the primary cost drivers based on the strategic analysis input from the Consultants during 1986-87. Perhaps the Consultants used the historic data (mostly collected well before 1985-86, while a large proportion of the production jobs were carried out manually) which are no more valid after 1987-88 due to a change in market condition and demand. The system (of calculating overhead costs as 435% of direct labor) worked in favor of net and gross profits while hardly there were any operational and resource allocation changes (FY 1986-87 and 1987-88).

Overhead Costs: It is evident from exhibit 2, that even if the overhead costs were allocated to be 435% of the direct labor, the rates moved upwards over time (from 437% in 1986-87 to 576% in 1988-89 except a slight decline to 434% in1987-88). In 1988-89 due to outsourcing of Mufflers/exhausts and oil pans, there was a reduction in direct labor, while the indirect and overhead expenses increased sharply. As a result, the remaining products had to bear larger overheads, hence declining the net margins, while introducing more overhead cost to be absorbed by the rest of the products.

The consultants classified the products primarily based on product costs and cost competitiveness where:

Ð'* Product costs are based on aggregate "material", "direct labor and benefit" and overhead costs provided by the financial personnel, instead of getting different cost break ups for each of the product types.

Ð'* The products were classified as following: Class I: Fuel Tanks, Class II: Manifolds, doors and Class III: Muffler-exhaust systems and oil pans primarily based on the survey and input about competitiveness during 1986-87. However, based on exhibit 1 (1990) it seems the automations and productivity improvements played a big role to bring in changes to cost drivers.

As a result, a single cost pool with direct labor costs as primary cost drivers and fixing overhead costs at the budget time at a flat rate certainly distorted the total cost for all the products. It also, explains why the overhead costs were in upward trend, since costs related to machinery and equipments are part of the overhead costs.

2. How would you recommend that Bridgeton make the decision on whether or not to outsource manifolds for 1990/91? Be as specific as you can by giving a "decision rule" of the form: "Outsource the manifolds if [ ] is greater than [ ]. You do not have to actually make the determination of what they should do, but you need to explain how the production and accounting teams should work together to provide the answer. What key numbers should they be estimating and computing?

It seems at present (by the end of FY 1989-90) the direct labor costs as a percentage of total cost considered to take the decisions on whether or not to outsource any product(s) (including Manifolds). Based on a list of assumptions (due to unavailability of number of units of production data), I would recommend that Bridgton should not outsource the manifolds , while reexamining other products which have been outsourced so far to evaluate for profitability. The analysis and assumption details are covered in "Analysis"