Vinylo Group Case Study & D&A Wire Co. vs. the United States of America

VINYLCO GROUP

Prologue

As soon as Jasmin Oesch received the September 2006 Profit Statement for her Tri-cities Rubber Division of VINYLCO (Exhibit 1), she called her Controller and Sales Manager into her office to discuss the results. Next week, as division manager, she would make her presentation to the VINYLCO Management Board and the results were not as good as expected. Jasmin knew that Tri-cities had performed well. Sales to her target customers were up and costs on the whole were down. She wondered why the bottom line looked so bad. Jasmin also knew that Peter Hofmann, her counterpart in the Copenhagen Division, was doing much better. The Board would likely compare Copenhagen profits (Exhibit 2) to Tri-cities’ performance. How would the Board react?

Background and Operations

As part of a large European conglomerate, VINYLCO Group produced synthetic (artificial) rubber used in a variety of applications. Major competitors included Goodyear, Exxon, and Dupont. VINYLCO competed in two product categories or lines; a regular type rubber traditionally used in inner tubes and general purpose applications (hereafter, R-line) and a more specialized type (hereafter, S-line). S-line products were similar to R-line rubbers but also had additional properties that allowed bonding to other materials (e.g., liners and sidewalls in tubeless tires). Both R-rubbers and S-rubbers were produced from basic raw materials such as crude oil, naphta, butane, propane, and ethane.

VINYLCO manufactured its rubber products in three operating divisions, all managed as profit centers; Tri-cities (Iowa) which focused on R-line in North and South America, Akron (USA) which focused on S-line products in North and South America, and Copenhagen (Denmark) which catered to customers in Europe and the Middle East for both R-line and S-line products. In addition to the three operating divisions, the VINYLCO Group included a Global Marketing Department and a Research Division. The costs of these departments were not charged to the operating divisions, but instead were charged against Group profits.

The original VINYLCO rubber plant was built in Tri-cities around the time of World War II when R-type rubbers were becoming increasingly useful in a variety of consumer and military applications. While R-rubbers continued to be VINYLCO’s main focus over the next several decades, innovations in production technology and changes in market demand (e.g., increasing rubber applications and demand for S-rubbers) required significant capital upgrades and the ability to produce both regular and specialty rubbers. Partly in response to market and technological trends, in the early 1980s VINYLCO built a state-of-the-art plant in Akron Ohio that focused exclusively on S-rubber products. At the same time, it committed to upgrading the Tri-cities plant over the coming decades with its renewed focus on producing R-type products. For instance, recently in 2003, VINYLCO upgraded its Tri-cities facilities at a cost of over $100 million, which among other things increased the facility’s nameplate (i.e. design) capacity of regular R-rubbers to 95,000 tons of rubber per year.

The Copenhagen plant was built in the 1970s. At first, it was also built as a regular R-rubber unit but was modified in the 1990s to allow it to produce both R and S rubbers. The annual nameplate production capacity of the Copenhagen plant was 90,000 tons of rubber. In 2005, as in previous years, the Copenhagen plant operated near or at its nameplate capacity with a little more than half of the capacity dedicated to meet its entire S-rubber demand. Copenhagen capacity not used to produce S-rubber was used to produce regular R-rubber. However, because demand for Copenhagen’s regular R-rubber in Europe and the Middle East outpaced the plant’s remaining capacity, Copenhagen satisfied its shortfall by purchasing R-rubber from Tri-cities.[1]

In order to facilitate the transfers of regular R-rubber from Tri-cities to Copenhagen, in September and October of each year, Tri-cities and Copenhagen divisions prepared production estimates for the upcoming year. These estimates were based on estimated sales volumes and capacity utilization. Because the Copenhagen plant operated at nameplate capacity already, the planning exercise was largely for the benefit of the managers of Tri-cities who needed to know how much regular R-rubber Copenhagen would need from Tri-cities. Exhibit 3 highlights the shipments of regular R-level shipments from Tri-cities to Copenhagen.

Product Costing

The accounting system in all divisions was a standard full absorption cost system. Variable production costs included the costs of raw materials, chemicals, energy, and some labor. Because raw material prices varied with worldwide market conditions, standard costs for many of these inputs were revised frequently, usually on a monthly basis.

Fixed costs included indirect labor, utilities, support service costs (e.g., engineering, procurement, etc.,), and depreciation. Standard fixed costs were assigned to production based on a plant’s “demonstrated capacity” as follows:

Demonstrated Capacity was defined in the Controllers’ manual as:

Demonstrated capacity is the annualized production that is practically attainable; taking into account the likelihood of abnormally low or high unscheduled production, scheduled shutdowns, and unusual or annualized items which impact either favorably or unfavorably a period’s production.

Managers at both Copenhagen and Tri-cities were encouraged to produce at or near demonstrated capacity. Product transfers between Tri-cities and Copenhagen for performance reporting purposes were recorded at standard full cost, representing for each ton the sum of standard variable cost and standard fixed cost. There were no product transfers to or from Akron.

Performance Evaluation and Compensation

Historically, employees at the VINYLCO Group had been paid by fixed salary with little use of bonuses except at the senior executive level. In 2004, a bonus system was instituted throughout VINYLCO to link pay with performance and strengthen the profit center orientation of the Group. For non-management employees, annual bonuses were awarded, in amounts up to 10% of salary, based on Group and Divisional performance. For managers, the annual bonus was greater than 10% and increased with responsibility levels.

The bonuses for top Division management in 2005 were calculated by a formula that awarded 50% of bonus potential to meeting and exceeding Divisional profit targets, 30% to meeting or exceeding VINYLCO Group profit targets, and 20% to meeting or exceeding overall parent company corporate profit targets.

Jasmin Oesch and Peter Hofmann

Jasmin Oesch was Vice-President and Division Manager of the Tri-cities Division. A professional engineer, she had begun her career with VINYLCO in plant management. Over the years, she had assumed responsibilities for product management as well as sales. She remarked:

My rubber business is managed largely on price and margin. Quality, service, and technology are important, but it’s difficult to truly differentiate ourselves from other competitors on these dimensions. It’s also important to note that this is a continuous process industry. The plant is computerized so that we need the same number of people and incur most of the same overhead costs whether the plant is running fast or slow.

Unfortunately, my Tri-cities plant is running at less than capacity. Although with the recent upgrades the plant should be able to produce 95,000 tons, its annual demonstrated capacity currently is 85,000 tons. In 2005, we actually produced 65,000 tons of R-rubber, well below even the demonstrated capacity. For 2006, we were expecting a little more than 65,000 tons but I am not sure we’re going to hit 85,000 anytime real soon. For instance, so far for the first 9 months of 2006, our production target was about 55,000 tons of R-rubber but it didn’t quite turn out that way; we produced 47,500 tons instead. Of course, it didn’t help that Copenhagen took a lot less rubber volume than they had projected. I suppose I could have produced 55,000 tons but I didn’t want to carry the extra inventory. You see, we get charged for working capital in our profit report and I didn’t want to take a hit for the extra inventory.

Peter Hofmann, Vice-President and Division Manager of the Copenhagen Division, was also a professional engineer. His career included management responsibilities in plant operations, market research, venture analysis and corporate planning. He remarked:

The Copenhagen plant typically produces about 45,000 tons of regular R-rubber and 45,000 tons of S-rubber. In addition, we import approximately 15,000 to 20,000 tons regular R-rubber from Tri-cities. We inform Tri-cities each Fall of our estimated needs. These estimates are based on our sales forecasts and how hard we can push our plant. For example, we budgeted to produce 150 tons of R-rubber per day this year and we have got it up to about 175 tons per day. Why not – if I can squeeze more out of my plant here, why bother shipping it from Tri-cities.

The Copenhagen operation has been extremely successful since I arrived here in 2002/2003. We have increased our market share and we’re running the plant better than ever. Looking at our Profit Statement for R-rubber only (Exhibit 2), our margins are better than Tri-cities’. While our plant is quite a bit older than Tri-cities’ plant and the market dynamics are a bit different in Europe than in North America, I sometimes tease my good friend Jasmin in Iowa that my success here is attributable to my superb management.

Exhibit 1

Tri-cities Rubber Division – Statement of Divisional Profit

Exhibit 2

Copenhagen Rubber Division – Statement of Divisional Profit (R-rubber products only)

Exhibit 3

Schedule of shipments of R-rubber from Tri-cities to Copenhagen

Case 2

D&A Wire Co. vs. the United States of America

In 1994, D&A Wire Co. (plaintiff) petitioned the U.S. Courts for redetermination of an excessive profits recovery order issued by an independent audit agency of the executive branch that monitored defense contractors’ profits. Mandating a refund from the company, the order stated that D&A realized excess profits of $591,000 in 1990 and $203,000 in 1991 on contracts for the production of field wire. Field wire was nylon-­coated, two‑strand communications wire used by the Department of Defense. It was packed in special canvas sacks designed so that it could be laid out quickly by airplane or helicopter to establish battlefield communication networks.

The field wire contracts had been of a fixed‑price type based on competi­tive bids; however, the contracts were also subject to renegotiation. According to established renegotia­tion procedures, the reasonableness of profits was to be determined by an overall evaluation of the particular factors present in a company’s situation. For example, consideration was to be given to the “reasonable­ness of costs and profits, with particular regard to volume of production, normal industry earnings, and comparison with commercial products.”

According to the audit agency’s order, D&A had earned the following on the field wire contracts:

1990 1991

Sales $8,732,000 $11,302,000

Profit 1,595,000 1,503,000

Profit as a percent of sales 18.3% 13.3%

These profit figures differed slightly from those reported by D&A (in exhibit 1 below) because the audit agency had added back “advertising” because it considered allocation of advertising expenditures to government work to be inappropriate and unallowable.

COMPANY BACKGROUND

The plaintiff operated five plants in three states, but only one of the plants located in Baltimore produced the field wire. This plant also produced commercial products, and there were very few interplant shipments to or from the Baltimore plant. The field wire contracts began in 1989 and ended in 1993; only the operations for 1990 and 1991 were subject to the excess profit recovery order, how­ever. The contracts called for shipments of approximately 60,000 units per year, but during 1990 and 1991 volume was much higher due to the requirements of the first Persian Gulf War. D&A had no other government contracts other than the one for field wire.

Costing Procedures

The plaintiff’s costing system at the Baltimore plant was relatively straightforward. Under this system material and direct labor costs were collected separately for commercial and government products. Indirect manufacturing costs which could be specifically iden­tified with government or commercial products were assigned accordingly to each product segment. Typically, these specifically identifiable indirect costs constituted a very small fraction of total indirect manufacturing costs. The total of material, direct labor, and specifically identi­fied indirect manufacturing costs were termed incurred costs. During the five years that the Baltimore plant produced field wire, the total incurred costs for government work as a percentage of total incurred costs at the Baltimore plant were approximately:

Year Government’s Share of

Incurred Cost (%)

• 57
• 67
• 69
• 77
• 54

Indirect manufacturing costs not specifically identifiable with government or commercial products were allocated to the two product segments as a percentage of total incurred costs. Thus, in 1990, approximately 67% of the unidentifiable indirect manufacturing costs at the Baltimore plant were charged to government contracts. Selling expenses such as salaries were charged to government work only to the extent that clerical workers devoted time to the orders, shipments, transportation, and billing paperwork. Advertising and related expenses “deemed necessary to hold or regain market position due to assignment of a high percentage of facilities to government business” were allo­cated on the basis of incurred cost. But, as noted above, these were ultimately disallowed. General and administrative expenses, except for certain specifically excluded items such as bad debts, entertainment, credit and collections and patent related expenses, also were allocated to government work on an incurred‑cost basis.

Operating statements for the plaintiff in total (i.e., for all five plants) and for the government contract (at the Baltimore plant) separately are shown in exhibit 1. The various categories of indirect manufacturing costs for 1990 and 1991 for the corporation as a whole are shown in exhibit 2. Thus, in 1989 the plaintiff’s total sales were $41.9 million including $7.4 million for field wire pulled at the Baltimore plant and $34.5 million for all other products including the Baltimore plant’s commercial products. In 1992, the company switched from a calendar year to a fiscal year ending in March. As a result, the 1992 “operating year” was only three months long.

Profitability

In defense of their position, D&A Wire argued that their return on assets were not out of line with other manufacturing firms of comparable size and doing similar work. They also noted that the return on sales for the field wire contracts was not much higher than the return on sales for commercial work produced at Baltimore. Operating statements for the commercial products alone are shown in Exhibit 3for the years 1988 to 1993. Commercial business volume did not change substan­tially during the period 1989‑90although the product mix changed somewhat; many new products were introduced during 1990 to 1992, primarily based on the profitability displayed by the commercial business in 1989 and 1990.

D&A Wire also argued that the Baltimore plant had undertaken a number of steps to be more efficient and productive and that cost savings had been passed on to the government through price reductionsas shown below.

1989 1990 1991 1992 1993

Volume of wire 60,000 82,000 130,000 42,000 82,000

Average sales price $123 $106 $87 $82 $74

Finally, D&A Wire argued that conventional accounting statements did not pick up the true value of Baltimore’s assets used to produce field wire because while many of the assets and equipment were fully depreciated, they were still in good condition.

The government’s audit agency determined that 11.5% profit before tax (as percent of sales) was the normal profit for this industry, and on this basis, made the excess profit claim previously mentioned. D&A Wire objected to this assessment and brought the matter to court.

Exhibit 1: D&A Wire vs. the United States of America: Total Corporate and Defense

Department Contract‑Statement of Operations ($000)

1989 1990

Total Government Other Total Government Other

Net sales $41,924 $7,409 $34,514 $42,974 $8,732 $34,242

Cost of goods sold:

Materials 20,069 3,389 16,680 20,755 4,859 15,896

Direct labor 4,227 921 3,306 3,843 549 3,294

Indirect manufacturing 8,932 1,834 7,098 8,450 1,371 7,079

Total cost of Goods sold 33,228 6,144 27,084 33,048 6,779 26,269

Selling and advertising:

Salaries 743 48 695 812 57 755

Commissions 833 ‑ 833 776 ‑ 776

Other 661 3 658 739 2 735

Advertising 178 ‑ 178 267 49 220

Total selling and advertising 2,415 51 2,364 2,594 108 2,486

General and administrative:

Salaries and wages 1,136 119 1,017 1,162 153 1,009

Other 1,026 127 899 750 146 604

Total general and administrative 2,162 246 1,916 1,912 299 1,613

Total costs and expenses 37,805 6,441 31,364 37,554 7,186 30,368

Operating profit $ 4,119 $ 968 $ 3,151 $ 5,420 $1,546 $ 3,874

1991 1992 1993

Total Government Other Total Government Other Total Government Other

$49,029 $11,302 $37,727 $11,785 $3,433 $8,352 $43,740 $6,049 $37,691

24,826 6,866 17,960 6,283 2,324 3,959 22,179 4,365 17,814

4.249 857 3,392 1,070 265 805 3,902 462 3,440

9,615 1,636 7,979 2,365 465 1,900 9,509 1,120 8,389

38,690 9,359 29,331 9,718 3,054 6,664 35,590 5,947 29,643

 813 70 743 204 15 189 829 53 776

865 ‑ 865 179 ‑ 179 875 ‑ 875

739 4 731 175 2 172 732 5 725

231 57 178 46 12 35 209 40 171

2,648 131 2,517 604 29 575 2,645 98 2,547

1,191 170 1,021 301 51 250 1,196 136 1,061

1,112 196 916 27957 222 4,224 153 4,071

2,303 366 1,937 580108 472 5,420 288 5,132

43,641 9,856 33,785 10,902 3,191 7,711 43,655 6,333 37,322

$5,388 $1,446 $ 3,942 $883 $ 242 $ 641 $85 ($ 284) $ 369

EXHIBIT 2:

 D&A Wire vs. the United States of America: Indirect Manufacturing Costs – Corporate Totals ($000)

1990 1991

Indirect Labor (including fringe benefits) $2,500 $2,701

Production management and Administration 3,066 $3,250

Maintenance, supplies, repairs 1,488 $1,622

Building and occupancy (including depreciation) 1,128 $1,350

Other 268 692

Total $8,450 $9,615

EXHIBIT 3:

D&A Wire vs. the United States of America: Statement of Operations – Commercial Products at Baltimore Plant ($000)

1992

1988 1989 1990 1991 (3 months) 1993

Net sales $6,439 $5,389 $4,661 $5,489 $1,195 $5,945

Cost of goods sold:

Materials 2,817 2,302 1,975 2,866 633 3,447

Direct labor 900 912 628 615 135 678

Indirect manufacturing 1,565 1,337 680 783 155 1,080

Total 5,282 4,551 3,283 4,264 923 5,205

Selling & advertising:

Salaries 223 175 183 222 56 262

Commissions 52 28 53 92 24 74

Other 203 197 217 249 57 270

Advertising 24 24 25 27 4 35

Total 502 424 478 590 141 641

General and Administrative 365 213 168 206 41 283

Total costs and expenses 6,149 5,188 3,929 5,060 1,105 6,129

Operating Profit $290 $201 $732 $429 $90 $(184)

[1] Although customers occasionally purchased/received shipments from the divisions outside their designated geographic region, such shipments were rare. For instance, cost and/or logistical considerations usually precluded European customers from buying from Tri-cities.

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