Case Analysis

On
Garner Company
(Case #6 – Cost Formulas, Single and Multiple Cost Drivers)

I. Introduction

For the past 5 years, Garner Company has had a policy of producing to meet customer demand.
As a result, finished goods inventory is minimal, and for the most part, units produced equal units
sold.

Recently, Garner’s industry entered a recession, and the company is producing well below capacity
(and expects to continue doing so for the coming year). The president is willing to accept orders
that at least cover their variable costs so that the company can keep its employees and avoid
layoffs. Also, any orders above variable costs will increase overall profitability of the company.
Toward that end, the president of Garner Company implemented a policy that any special orders
will be accepted if they cover the costs that the orders cause.

To help implement the policy, Garner’s controller developed the following cost formulas:
Direct Material Usage = $94X, R² = 0.90
Direct Labor Usage = $16X, R² = 0.92
Overhead = $350,000 + $80X, R² = 0.56
Selling Costs = $50,000 + $7X; R² = 0.86
where X = direct labor hours.

II. Important Case Facts

1. As a company policy, Garner used to produce only the customers’ demand resulting in small
finished goods inventory or no inventory at all.

2. Garner’s industry is currently in a recession.

3. The company is willing to take orders that will at least cover the variable costs of producing
and selling the items, to retain the current employees and prevent layoffs.

III. Point of View

This analysis is taken in the point of view of the management of Garner company.

IV. Statement of the Problem

 What should management do to remain competitive and stable during the recession?

V. Statement of Objectives

 To come up with a strategy that will make the company stable and minimize the effect of the
recession to its operations
 To increase, or at least maintain, the current profit level that the company has.
 To think of a plan to maintain current employees thus preventing layoffs during the recession
 To achieve all the above mentioned objectives while being ethical at all times
VI. Analysis

A. Computational Analysis

Here are the answers to the questions raised by the author in the book:

1. Compute the total unit variable cost. Suppose that Garner has an opportunity to accept an order
for 20,000 units at $212 per unit. Each unit uses one direct labor hour for production. Should Garner
accept the order? (The order would not displace any of Garner’s regular orders.)

The total variable cost of producing and selling one unit is $197. This total includes variable
cost of materials ($94), labor ($16), overhead ($80) and selling expense ($7). The special order
should be accepted since the price of $212 per unit is higher by $15 than the variable cost per unit
of $197, deriving an additional contribution margin of $300,000 ($15 x 20,000 units).

2. (Appendix 3A) Explain the significance of the coefficient of determination measures for the cost
formulas. Did these measures have a bearing on your answer in Requirement 1? Should they have
a bearing? Why?

The coefficient of determination is a measure of reliability of the cost formulas. Based on

the given, all cost formulas seem to be reliable except for the overhead which has a coefficient of
determination of 0.56 only. This means that only about 56% of the variability of overhead cost is
related to the direct labor hours. This should have a bearing on the answer to Requirement 1 since
there are other activity drivers aside from direct labor hours that affects the variability of the
overhead cost. Simply stated, the variable component of the overhead cost cannot be represented
to depend on labor hours alone.

3. (Appendix 3A) Suppose that a multiple regression equation is developed for overhead costs:
Y=$100,000 + $85X1 + $5,000X2 + $300X3, where X1 = Direct Labor Hours, X2 = Number of
Setups, and X3 = Engineering Hours. The coefficient of determination for the equation is 0.89.
Assume that the order of 20,000 units requires 12 setups and 600 engineering hours. Given this
new information, should the company accept the special order referred to in Requirement 1? Is
there any other information about cost behavior that you would like to have? Explain.

Materials (20,000 x $94) $1,880,000

Labor (20,000 x $16) 320,000
Variable overhead
(20,000 x $85) 1,700,000
(12 x $5,000) 60,000
(600 x $300) 180,000
Variable selling (20,000 x $7) 140,000
 Total variable cost of the order $4,280,000
Divided by: number of units 20,000
Variable cost per unit $214

The special should not be accepted anymore since the price per unit of $212 is higher than
the variable cost per unit of $214, a loss of $2 per unit if order is accepted.

B. SWOT Analysis

Based on the facts given, the following are identified under the SWOT analysis for the company:
STRENGTHS WEAKNESS

- The company’s strategy before the - Using just-in-time inventory is prone

recession to produce only the to having stock-outs, especially if
customers’ demand was a good the company do not maintain safety
move to reduce handling costs of stocks
ending inventory, if any (Just-in-time
inventory system)
- Management’s plan to accept special
orders that will at least cover the
variable costs of producing and
selling the products will help the
company stay stable amidst strong
competition during the recession
- The plan to accept special orders is
also very ethical since the company
doesn’t want to remove its employees
(layoffs)

OPPORTUNITIES THREATS

- The company’s action to prevent - The recession, per se, is a threat to

layoffs will increase the employees’
morale and its effect can be seen
even after the recession has stopped
- Through special orders, the company
is basically expanding its market and
the clients from these special orders
can be retained after the recession
the company
- The increased competition due to
the recession might gravely affect
the company especially if it will not
plan well how to combat its effects

VII. Alternative Courses of Action

ACA 1: Status quo

In this ACA, management will not do anything about the recession and will simply continue to
produce only the customers’ demand.
 PROS CONS

● No further action is needed to be ● The company will incur losses if the

done company will continuously produce
● Saves time and effort below its capacity since costs,
especially labor and fixed costs, are
not fully utilized
● If the company decides to remove
employees due to excess capacity, it
will affect the morale of the other
employees

ACA 2: Accept all special orders within capacity having a price equal to or greater than the total
variable cost of producing and selling the product. Also, the company should consider selling the
excess capacity to another company, whichever will be more profitable to the company.

Disregarding the coefficient of determination provided in the given, the company can accept special
orders with a price of at least $197 per unit, which is the total variable cost per unit (94+16+80+7).
If the coefficient of determination will be considered and multiple cost drivers will be used to
determine the variable cost, the company should first compute the total variable cost of an order
then divide it with the number of units in the order to get the variable cost per unit; this will now be
the minimum price that the company can accept.

In case excess capacity still exist after receiving special orders (assuming competition increased
even more due to the recession), the company can consider selling its excess capacity in another
company that is similar to the company but is not a direct competitor. For example, if the company
is a publisher who prints educational books, it may consider contacting children’s book publishers
or publisher of novels, but not publishers of other educational books.

PROS CONS

● Employee productivity and morale ● Selling excess capacity requires

will be high thorough planning and is not very
● Excess capacity will be utilized and easy to implement
there’s opportunity to increase, or at ● Accepting special orders that cover
least maintain, current profit level the variable costs is not a
● More clients will be tapped for the guaranteed success since
special orders and they can be competitors in the industry might do
maintained even after the recession the same

ACA 3: Develop a new product or service in an industry not affected by the recession so that the
excess capacity is utilized and at the same time earning profits

This alternative will require the company to plan thoroughly since a new product or service will be
developed. If successful, the company will be able to expand its market and increase its profitability.
However, if this will not be successful, a big loss will be incurred since the excess capacity was
allocated to an activity that is not profitable. Both the cost of excess capacity and the loss for the
new activity will affect the bottom line of the company’s performance.

PROS CONS
 ● Employee productivity and morale
will be high
● Excess capacity will be utilized and
there’s opportunity to increase, or at
least maintain, current profit level
● The company will be able to increase
its market if the new product or
service becomes successful
● Developing a new product or service
will be very tedious since this will
require market study to be
successful.
● Time, money and effort will be
required for this

VIII. Decision Criteria

Please see below the decision criteria used in arriving with the chosen course of action to solve the
problem in hand:

Criteria ACA #1 ACA #2 ACA #3

Ease of 20 15 15
implementation (20
points)
Cost/cost savings (20 17 18 15
points)
Process improvement 12 18 17
(20 points)
Increase in customer 12 19 18
satisfaction (20
points)
Risk level (20 points) 5 17 15
Total Score 66 points 87 points 80 points

IX. Recommendation

Based on the given alternative courses of action and the pros and cons, our recommendation is:

ACA 2: Accept all special orders within capacity having a price equal to or greater than the total
variable cost of producing and selling the product. Also, the company should consider selling the
excess capacity to another company, whichever will be more profitable to the company.

The main goal is for the company to remain competitive, stable and, of course, ethical during the
recession. The chosen ACA is the best alternative because of the following reasons:

● The company will be able to use its excess capacity and at the same time, will remain
profitable even during the recession
● Employee morale will be high since they will feel that the company values them
● New customers accommodated can be retained even after recession; an opportunity for
the company to expand its market
X. Implementation

The chosen course of action shall be executed using the steps mentioned below:

1. Coordinate to key managers, especially the marketing manager, the plan to accept special orders
that will at least cover the variable costs of producing and selling the product.

2. Choose the special orders that will give the company the highest total additional contribution
margin (contribution margin per unit x units to be sold in special order), as long as the units to be
sold can be covered by the excess capacity of the company.

3. Create a good relationship with the customers placing special orders since these are potential
employees even after the recession.

4. If not enough special order is received due to the competition and the company still has excess
capacity, it may consider selling its excess capacity to another company. In selling excess capacity,
the company should consider all incremental cost resulting to such sale so that a reasonable price
may be derived.

5. Properly plan and consider a mixture of the two alternatives (accepting special orders and selling
excess capacity), provided that profit is maximized and excess capacity is fully utilized.

XI. Learning Points

From the case that was reviewed and studied, the following were the learning points of the group:

● The company’s care to its employees (in this case, preventing layoffs) is very important
since this will result in higher morale and productivity of employees; it is not always about
profit. The company chose to be ethical and made a way to retain its employees during the
recession.

● The most practical way to use excess capacity is really to accept orders that will at least
cover the variable cost related to the product. In this manner, additional contribution margin
will be derived and overall profit will be increased.

● In any decision, management should not only consider qualitative items (profit, cost, etc.)
but should also other matters that will affect the company such as employee morale, public
image, and the like to remain stable and competitive.