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The Exceptional Connector Division of the Tyco Corporation founditself in a position typicalof fast-growing companies. Although sales revenues were increasing rapidly, capital equipment allocations from Tyco were less than desired, and profits were variable. Joseph Chang, the General Manager of the division, enrolled that year in a seminar on "Contribution Income" sponsored by the Canadian Management Organization Association (CMOA). According to Chang, "Before I went to that seminar, my knowledge of contribution income was limited to casual comments that I overheard at group general managers' meetings. A large acquisitionin the automotive after-market industry had always used a contribution income approach in its accounting systems. All other segments of the Tyco Corporation used the full absorption method in product costing, but thiscompany wasallowedto keepits variable costing system becausea forced change of systems at the time of acquisition would have been too disruptive."

Chang believed that the full absorption reports used in his division were accurate. He and Francisco Bruno, the Division Controller, were confident that they knew the total manufacturing cost of each of their products. However, Chang did not have the same confidence in his staff's ability to determine how changes in output quantities would affect profits. He wasconvinced that better utilization of plant and equipmentanda moreeffectivepricingstructurewould lead to substantially improved earnings. The division was not as profitable as others in the industry or other similar-size divisions in the corporation that had comparable manufacturing processes.

The Contribution Income Approach

A main point of the CMOA seminar was that product lines do not produce profits, they produce contribution income (sales revenues minus variable costs) which can become operating income only after fixed costs arecovered.Theseminar also underscored not only the importance of cost behavior analysis but also the arbitrariness of many fixed cost allocations. Joseph Chang immediately saw in contribution income a new approach to solving Exceptional Connector's problems with both product mix and pricing decisions.

Chang discussed the subject of contribution income with Tyler Emerson, the Group Controller. After discussing the advantages and disadvantages of the approach, Chang recommendedthat his division's product costing system be overhauled for the third time since Tyco Corporation acquired Exceptional Connector ten years ago. Emerson agreed to support a change in the management reporting system, but pointed out that the contribution income approach was contrary to the reporting philosophy of thecorporationand,for external reportingpurposes, did not comply with IFRS, S.E.C. reporting requirements, and Canadian Revenue Agency directives on inventory valuation.

When the decision to proceed was made, Francisco Bruno and hisaccountingstaff used regression analysis to classify manufacturing costs, administration and other operating costs, and marketing and distribution costs as either variable, fixed, or mixed. Mixed costs were separated into their variable and fixed components. Fixed costs then were identified as either discretionary (amounts to be expended based on decisions made annually or at shorter intervals) or committed (usually not subject to change in the short- run). A booklet on contribution income which Joseph Chang gave to his staff stated that fixed costs only change overtime, but variablecosts(1) varydirectly withchanges in output levels, arid (2) are usually expressed as a percentage of salesdollarsor direct manufacturing labor dollars.

A Special Order

The Cameron Company, which was experimenting with various components of its product line, offered to purchase 6,000 Hydro-Con multi-function control connectors from Exceptional for $160 each. Cameron would need 500 units per month with delivery commencing at the start of the new year. The special order would be in addition to the 80,000 Hydro-Con control connectors that Ralph Dickenson, the division's Marketing Manager, expected to sell at the regular $200 price. Dickenson considered the order to represent an excellent opportunity to increase long-term sales volume because it would be a new application for the Hydro-Con control connectors. He negotiated a flat $48,000 commission with the selling distributor.

Joseph Chang was concerned that cutting the price of the connector would set an undesirable precedent. He pondered the special deal for several days before going to see Ralph Dickenson. "The price is below our full cost of $175 per unit/' he said. "If we accept the Cameron proposal, they may always expect favored treatment."

Chang asked Dave Good, the Manufacturing Manager, and Francisco Brunoto join this discussion in Dickenson's office. When they arrived, he asked, "What is the division's capacity for making Hydro-Con Control?" Good's reply was "One hundred thousand (100,000) units per year, if we don't retool any machinesdedicatedto another product line."

Francisco Bruno presented the following standard manufacturing cost data for Hydro- Con connectors:

Direct materials

$ 35

Purchased components

30

Direct manufacturing labor

12

Manufacturing overhead

44

Total standard manufacturing cost

$121

After distributing copies of the budgeted income statement for the upcoming fiscal year (see Exhibit 11-Al), Bruno revealed that variable manufacturing overhead for the 80,000 unit Hydro-Con budget was $2,400,000. Variable "administration and other operating expenses" totaled $4 per unit; a 10% distributor commission ($20 per unit) comprised the variable portion of marketing and distribution costs. TheControllerfurther indicated that manufacturing adjustments represented production variances and further indicated that manufacturing adjustments represented production variances and scrap, which he expected to vary with the number of connectors produced. At the budgeted output level, fixed administration and other operating expenses wouldaddan average of $16 to unit cost.

As the discussion continued, Ralph Dickenson reviewed next year's budget.Ofthe total fixed marketing and distribution costs, $160,000 was earmarked for future advertising space in several trade publications and an upcoming trade show. The remainder of the budget related to salaries and other firm commitments.

The Hydro-Con budget was designed to fully absorb all costs at the 80,000 unit production denominator level. The other product line budgets also were designed to fully absorb costs at budgeted volume levels and all fixed costs were expected to remain unchanged until the current maximum capacities were surpassed (see Exhibit 11-A2).

Joseph Chang asked his Division Controller what effect the Cameron offer would have on profits. Bruno's response was evasive. It was apparent that hehadnot previously studied the effects that volume changeswould have on division operations.

Production Line Elimination

Exceptional Connector's marketing department prepared a sales order plan for each new year in terms of both units and dollars by product line.TheProduction Control Department then used the order plan to develop a sales shipment plan for each of the division's three plants. Ralph Dickenson had very little marketing information to use in developing the "Made to Order" Hydraulic Control product line plan. However, he knew that the line's compound growth pattern over the last three years had been quite disappointing, and he saw little prospect for substantial sales growth in the short-term future.

Dickenson recommended that the division consider eliminating theMadetoOrder line. Dave Good had assured him that the M-T-0 dedicated machinery could be retooled to produce either of the standard lines. Dickenson was convinced that he could develop a market for the additional standard product in a relatively short time, and he strongly believed that the division should concentrate on its two basic product lines. "After all," he commented, "that's where we're most successful." The DivisionController, Francisco Bruno indicated that, if forwhateverreasonadditionalunitsofthe standard product could not be sold and the M-T-0 line were shut down, the Division could save another $225,000 in fixed costs.

At the last staff meeting of the year, Joseph Chang told Dickenson that he would study the product line elimination proposal af ter he made a decision on the Hydro-Con special order. He assigned the proposal top priority for the new year.

Required:

1.Recast the budgeted product line income statement for the Exceptional Connector Division presented in Exhibit 11-Al into a budgeted contribution (marginal) income product line income statement. Assume that inventories will not change during the year.

2.Should Joseph Chang decide to accept the Cameron Company special order?

3.Should the Exceptional Connector Division eliminate the Made to Order product line if there were no alternative uses for its production capacity?

4.If all resulting standard products could be sold, how should the M-T-0 capacity be allocated? (Assume only the capacity currently being used to produce 20,000 M-T-0 units would be used to produce additional standard products.)

Exhibit 11-Al

Budgeted Product Line Income Statement for the Exceptional Connector Division (in thousands)

Hydro-Con

Pneu-trol

Made to Order

Total

Division

Revenues

$16,000

$13,000

$ 5,000

$34,000

Direct materials and purchased

components

5,200

3,900

1,300

10,400

Direct manufacturing labor

960

1,235

1,000

3,195

Manufacturing overhead

3,520

2,990

1.531

8,041

Total cost of sales atstandard

9,680

8,125

3,831

21,636

Gross margin

6,320

4,875

1,169

12,364

Adjustments

800

520

554

1,874

Gross margin after adjustments

5,520

4,355

615

10,490

Administration and other

operating costs

1,600

1,560

750

3,910

Marketing and distribution costs 1,9201,5606004,080

Operating income$ 2,000$1,235$ (735)$ 2,500

Exhibit 11-A2

Unit selling price

Variable manufacturing

Exceptional Connector Division Product Line Data

Pneu- trol

$50.00

M-T-0

$250.00

overhead costs per unit Variable administration and

other operating costs per

unit

Variable marketing and distribution costs per unit

6.50

1.50

5.00

50.55

5.00

25.00

Product Line

Hydro-Con Pneu-trol M-T-0

Present Max.

Capacity in Units

110,000

350,000

50,000

Machine Hrs./Unit

6

2

5

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