Statement of the Problem
What steps should Destin Bras Products Co. (Destin) take to address the current loss in market share due to a sharp decline in the price of competitors? How could Destin remain profitable in all of its market segments?
This is the question that the management of Destin, a local producer of valves, pumps and flow controllers is asking. What do the competitors know or how are they doing their business such that they remain profitable despite a significantly lower selling price. Destin is very competitive despite not having any design advantages, nor would any competitor so technical superiority is out of the question. Management thinks that the answer may be in how they figure out their manufacturing costs.
Destin uses a traditional approach to allocate overhead costs and determine unit prices. They use labor hours as a determinant but later changed it to machine hours to reflect the dominance of machine use in the manufacturing industry. This approach however, is superseded by the modern transactions-based approach. With a transactions-based approach, manufacturing takes into account longer-run (capital expense) recovery rather than short run (variable cost) recovery.
The results show that Destin could compete if it adheres to a transactions-based cost approach. As a matter of fact the difference between net income given the use of the original price from traditional accounting and a more competitive set of prices based on transactions-based approach is 757 thousand.
With these findings Destin could do the following:
1. For pumps, Destin could reduce its prices to gain market share. The proposed price of 53.34 reflects a 35% margin over unit cost; Destin could go lower than its current price of 81.86 to 53.64 per unit and still make the 35% margin requirement.
2. For flow controllers, Destin should sell at 162.28 to make a 35% market share. If the market cannot bear that price, Destin should continue selling but only up to an acceptable tolerance. It will reach break-even if the market can only afford to pay 105.48 per unit.
3. For valves, Destin could continue selling valves at its current price. But it can also reduce prices to gain market share.
Destin’s unit costs are determined using a traditional approach of determining the cost per unit given the raw materials, labor costs, machine costs, and overhead costs and then the addition of a 35% margin. Destin’s management however, is alarmed at the current market situation. It seems that its pumps are reducing neither market share despite the reduction in selling price while flow controllers have not gained nor lost market share and have in fact been unattractive to competitors despite a 12.5% increase in selling price (and larger computed margins). The calculation used by Destin is presented below.
Table 1 Destin Original Calculation for Unit Cost, Gross Margin and the Actual Selling Price and Gross Margin of its Products
This approach was “modernized” by Destin to substitute machine usage for labor usage. The rationale for this is that machines are the primary and therefore the more relevant factor for allocating costs. This modern take on cost accounting is shown below.
Management noted the use of transactions-based cost allocation for overhead costs. When this technique is applied to Destin, a different set of numbers are seen. The calculations follow the figures derived for direct variable costs including material cost, direct and set-up labor. Overhead costs are allocated using the number of transactions it takes to produce different products. These transactions have been summarized into percentages as they are allocated to the different products.
With transactions-based cost allocation, we see that the cost of valves, pumps and flow controllers are very far from the traditional costs calculated. These directly impact net income and gross margins. Originally, pumps were thought to provide 43% of total gross margin, followed by valves and then flow controllers. With transactions-based cost allocation, we see that pumps still contribute the most to revenue but not by a large difference. Also, flow meters are not providing any positive contribution but have a negative effect on gross margins. This could explain why despite the large increase in selling price, the market did not respond to the price change and why there Destin has no competitors in the segment.
Here is a summary of further actions that Destin can take to maximize profit and protect its market share.
4. For pumps, Destin could reduce its prices to gain market share. The proposed price of 53.34 reflects a 35% margin over unit cost; Destin could go lower than its current price of 81.86 to 53.64 per unit and still make the 35% margin requirement.
5. For flow controllers, Destin should sell at 162.28 to make a 35% market share. If the market cannot bear that price, Destin should continue selling but only up to an acceptable tolerance. It will reach break-even if the market can only afford to pay 105.48 per unit.
6. For valves, Destin could continue selling valves at its current price. But it can also reduce prices to gain market share.