You are on page 1of 5

Reichard Maschinen, GmbH MBA 611 Lucille Ausborn

In June of 1974, Mr. Kurtz, the managing director of the Grinding Machines Division (GMD) of Reichard Machines, held a meeting that would involve his sales manager, his controller and his product-engineering manager. This meeting concerned a competitors introduction of plastic rings to take the place of steel rings, a standard component in many grinding machines, including many made and sold by GMD. The new recently introduced plastic rings appeared to have a much longer life than the steel rings, but were also much less expensive to manufacture. The competitor currently manufacturing the plastic rings was Bruggeman Grinders, SA, a company located in Belgium. Mr. Kurtz currently had 25,000 steel rings in inventory and had recently purchased 26 tons of special steel alloy for the sole purpose of producing 34,500 more rings. The current inventory had been valued at around $93,000. Because the steel in inventory was a special alloy, it could not be sold as scrap and was unusable for anyone other than Reichard. Mr. Kurtz was faced with the following decisions: to begin producing plastic rings in September, to sell the steel rings held in inventory and dispose of the raw steel reserves, or to process the remaining steel into rings, sell the entire steel inventory, then move on to producing plastic rings. Costs associated with producing 100 units of both the plastic and the steel rings are below.
Per 100 Units Material Direct Labor Overhead Manufacturing Plastic $4.20 $15.60 $31.20 Steel $76.65 $46.80 $93.60

Selling and admin Total

$15.60 $66.60

$46.80 $263.85

The first alternative offered to RMG was to begin production of plastic rings as soon as possible. Because RMG would need until September to prepare for the plastics production, direct labor and materials costs would be fully merited as shown in the controllers estimation. For the short run, it was assumed that RMG would not expand their capacity at the same time they began producing a new product, so fixed overhead costs estimated by the controller were excluded. Those excluded overhead costs were replaced by the fixed overhead costs of the acquisition of molds and tooling for the new product, and the variable overhead (80% of labor costs). In calculating additional fixed overhead, it was assumed that the useful life of the new equipment was 6 years. It was also assumed that the demand for plastic rings would in the beginning be 10% of the current demand for the steel rings. Annual demand for the plastic rings was calculated as follows:

Annual demand for plastic rings = 690 units/wk*53wks*10% = 3657 units

The additional overhead cost per 100 plastic units was calculated as follows:

Cost per 100 units = (Acquisition cost/(useful life*annual demand))*100 = 10,000/(6*3657)*100

= $45.57 The following table illustrates the total costs to produce 100 plastic rings.
Differential costs to produce 100 plastic rings Material Direct Labor Variable Overhead Annual Demand for Rings Acquisition Cost Plastic $4.20 $15.60 $12.48 3657 $10,000.00

Useful Life Incremental cost per 100 units Total

6 $45.57 $77.85

Another alternative RMG had was to sell the steel rings already in inventory. If RMG were to sell the 25,450 steel rings they already held in inventory, their material, direct labor and variable overhead would be considered sunk costs and would not be considered as differential costs in any decision making process. Because the 25,450 rings are finished goods/ on hand inventory, there are no additional production costs resulting in the incremental costs for the steel rings being zero. It should be noted that the 70% of wages will be incurred during the summer, but this is common in all scenarios and will not be included in incremental costs.
Differential cost of Steel Rings per 100 (First 25,450 Rings) As Compared to Plastic Plastic Material $4.20 Direct Labor $15.60 Variable Overhead $12.48 Total $32.28 Revenue $340.00 Contribution Margin $307.72 Contribution Margin Ratio 90.51% Steel $0.00 $0.00 $0.00 $0.00 $325.00 $325.00 100.00%

A review of the contribution margin ratios between the plastic and steel rings shows that, at least for the first 25,450 rings, the steel rings are the more profitable. The third alternative for RMG involves the production of the next 34,500 steel rings from the raw steel still in inventory. With this alternative, RMG can complete the production of the steel rings during the slack summer season. In this scenario, they would incur direct labor costs; the wages paid in this period would be 30% of the regular wages. Material costs would be excluded due to it being a sunk cost and that the special

alloy steel has no scrap value and therefore offers no opportunity cost. Variable overhead would still be calculated as 80% of total labor costs.
Differential cost of Steel Rings per 100 (Next 34,500 Rings) As Compared to Plastic Plastic Material $4.20 Direct Labor $15.60 Variable Overhead $12.48 Total $32.28 Revenue $340.00 Contribution Margin $307.72 Contribution Margin Ratio 90.51% Steel $0.00 $14.04 $11.23 $25.27 $325.00 $299.73 92.22%

A comparison of the contribution margin ratios of both the plastic and the steel ring shows that for this short run volume, steel rings are less costly. Based on the controllers cost information, an analysis of the long-term profitability of producing plastic versus steel rings was conducted.
Per 100 Units Material Direct Labor Overhead Manufacturing Selling and admin Total Long-run Profitability Revenue Total Expenses Operating Income Profit Margin Plastic $4.20 $15.60 $31.20 $15.60 $66.60 Plastic $340.00 $66.60 $273.40 80.41% Steel $325.00 $263.85 $61.15 18.82% Steel $76.65 $46.80 $93.60 $46.80 $263.85

It is clear that although the first 59,950 steel units produced would be less costly, in the long run, after all pre paid for materials had been used, plastic would be much more profitable. Given that plastic production is not difficult and brings a higher margin than steel rings, it should be expected that the market would be very competitive. Even if RMG

does not produce the plastic rings, someone else will, resulting in the market shifting to plastic. By RMG introducing plastic rings into the market earlier, the company will be able to maintain their position as a leading producer of high quality machines on the cutting edge of technology. It is recommended that RMG shift to producing plastic

rings within the next year, and production of steel rings should be terminated after all of the remaining steel ring and raw material inventory has been depleted. The 15,000 units expected to remain in inventory at the end of September should be offered at discount prices to the low price low quality companies that had recently entered the market. To appease their established customers, RMG should offer reduced introductory rates for replacement parts for machines already purchased and in use. RMG should enter the market with a price below the established $340.00. A $15.00 reduction in price per 100 would be very profitable for RMG. As demand decreases it is recommended that RMG cut their prices as competition decrees. By maintaining their differentiation of producing high quality and technologically advanced products, expanding their customer base to new emerging markets, and following the other recommendations, Reichard Maschinen, Gmbh will enjoy continued success.