Bridgeton Industries

BRIDGETON INDUSTRIES

Introduction

Please note that Exhibit II of my chosen case study, Bridgeton Industries, has a few mistakes in the sub totals and therefore also in the total factory profit. I have corrected these in Attachment I and will therefore proceed to assess this case using my attachment and not Exhibit II.

The aim of this writing is to evaluate whether or not manifolds should be outsourced and to identify the reasons for sustained unprofitably at the Bridgeton Industries automotive component and fabrication plant despite improvements in the effectiveness and efficiency of production processes.

To resolve this problem I will first look at current and future profitability of the individual product lines and then examine the method of overhead cost allocation and the way in which costs are captured. I will then create an estimated model year 1990/1991 in order to evaluate the effect that the outsourcing of manifold production will have on the remaining plant operations and therefore also upon overall plant profitability. To close I will make suggestions as to what could / should be changed in order to improve transparency for future decision- making.

Product line profitability

Attachment 2 shows an overview of profitability by product line for the model years (in the following referred to as MY) from 1986 to 1989. Please ignore the estimate for MY 1990 at present, as I will come back to this at a later point in time.

The below tables summarize the gross margin, allocated overhead and net results as a % of sales over time. Table 1 below illustrates that fuel tanks are the most profitable items and Muffler / exhausts are the least profitable in MY 1986. However all products are covering their direct costs and are therefore able to contribute towards covering indirect and over- head costs. The situation does initially not seem to be very problematic. The table also documents that the company has been able to improve direct profitability of all product lines over time.

Table 1:

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Table 2 below shows the result per product line after all overhead and indirect costs have been allocated. The ranking order has not changed, but the discrepancies between the single lines have been enlarged. Muffler / exhausts are now 40 percentage points behind the fuel tanks in MY 1986 - previously the difference was only 26.6 percentage points. What is going on one may ask?

Table 2:

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Table 3 sheds some light onto the situation. For some reason the Muffler / exhausts

and Oil pan product lines are being charged very highly with plant overhead ex- penses. It is also interesting to note that the burden increases as product lines are removed. This means that the remaining products each have to carry an increased amount of overhead cost which leads to the decrease in profitability seen in table 2 above.

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Table 3:

This situation begs the question whether or not it was correct to outsource the Muffler / exhaust and oil pan product lines in the first place. Should they not have been kept as long as they were positively contributing to plant profit? Even if they are only covering their direct costs and some, but not all, overheads it could still be worthwhile to continue with production.

However, to realistically assess the situation information is required to the contribution that the outsourced products are currently making to profit. It is this contribution against which the in-sourced production has to be measured.

Overhead Cost Allocation

It appears that overhead cost allocation is a major source of the company’s problems.

Attachment 3 gives an overview of the development of profitability, overhead costs and the overhead allocation rates with the variance to the preceding MY as a %.

The first issue is that the MY 1986 rate is different from that which the consultants used. They stated 435% and actual would be 437,5%; this could be due to them using more actual figures seeing that the MY had actually begun at the time of the review. In fact their rate is much closer to the MY 1987 rate so it could be that they used this for their analysis.

The main item evident here is that the allocation rates change over time. The first change is in MY 1987 when it goes down. This has been caused by direct labour increasing by 2,5 % whereas overheads increased by only 1,8% in total. It is not a sign of increased efficiency, it is just a distortion resulting from the cost driver chosen and the mathematical consequences.

MY 1988 increases so sharply, as a result of the reduction in direct labour of -46.3% being higher than the reduction in overhead and indirect expense achieved through the outsourcing of the product lines. This means that each of the remaining product lines has to accept a larger amount of overhead, which further explains the decline of Net result as a % sales previously shown in Table 2. Therefore the outsourcing has increased overall company profitability when measured as a % of sales - as can also be seen in below Table 4 through improving the companies mix, but it has reduced the overall bottom line through both removing products that contributed to the bot- tom line and by decreasing individual product line profitability by giving the remain- ing products a larger proportion of the overhead burden to carry.

Therefore it appears that decisions have been made based upon the distorted messages being given by the current method of overhead allocation.

Table 4:

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There are three major problems arising from these distortive effects. First the company can enter a death spiral in that prices will be driven ever further upwards to cover increasing burden costs. Second the labour cost driver seems to have lost its relevance over time and consequently does not accurately represent resource usage anymore. Finally costs are being aggregated onto one cost centre.

It may be at a time when engines were being produced manual labour was a major factor, but now machinery does more work than is done by manpower alone. The time seems ripe to consider whether a machine hour, or even some other, rate would be more appropriate for the business.

A series of cost centres should be opened up for groups of machines and overhead departments. Within this structure service and production cost centres should be established, reciprocal relationships identified and solved and rates set on a cost centre for cost centre base. Labour is still a large cost block in the plant and it can well be justified to transfer certain indirect costs per direct labour. However all cur- rent products make strong use of automated processes making direct labour a bad way of allocating resource usage. Also the lack of cost centres causes in transparency by aggregating all production, product line and overhead costs into one pot.

It is now clear that direct labour has been a major influencer of the outsourcing decisions in the past. Please see attachment 4 that shows the proportion of direct labour per product line. It is no co- incidence that the companies with the highest percentage of direct labour in both MY 86 & MY 87 were those that were first

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