Background
Founded in 1922 by Gunnar Pelarsen, Pelarsen Windows is now in its third generation and is currently led by CEO Ingrid Pelarsen. The company experienced success in the 1990s, particularly through its shift from craft to mass production. This allowed for larger volume production and assembly at remote locations by standardizing various components. Additionally, Pelarsen Windows gained prominence due to its innovative products such as insulated glass, solar heating and cooling, and energy efficient windows. This innovative approach transformed glass from a commodity to a unique component in window manufacturing. The company produces two main types of windows – standard and architectural. Sales offices determine the assigned plant for orders based on factors such as available capacity, geographical proximity, and skill level needed. Currently, Pelarsen Windows operates in 15 plants across North America, employing 10,000 workers and holding a 34% market share in the windows manufacturing industry in North America. The focus of this case is to analyze the facts and provide recommendations on how the Texas plant can recover from the $6.34 million loss it experienced in 2007. The cause of this loss, as believed by Plant Manager Doug, is not necessarily linked to a decrease in the volume of architectural window business.Another suggestion he has is to invest in newer equipment. However, the analysis demonstrates that the issue is not only the higher labor costs and an aging facility. By re-calculating the cost data with ABC, the weaknesses in Doug’s suggested recommendations will become apparent.
Issues
The Texas Plant Manager, Doug Niedermeyer, is concerned about how window business is allocated between the Oregon and Texas plants. He has suffered a $6.34 million loss in 2007 and believes that the Oregon plant is given preferential treatment and receives more of the costly architectural business. Furthermore, Doug argues that the Oregon plant has advanced equipment that is highly automated, while the Texas plant faces the burden of expensive labor and capital charges. He believes that the two plants are not operating on an equal playing field. The following issues need to be analyzed:
Whether an increase in architectural windows business actually generates the profits Doug states, what is the ideal proportion of architectural versus standard windows production, how many production lines should be exclusively allocated to the architectural window business, whether there is enough capacity to support the planned output of architectural versus standard windows, and if increasing architectural window production will result in higher costs of quality due to increased prevention and inspection expenses for both product lines.
There are some additional matters to examine, such as:
The text explores various factors concerning the decision to increase production of architectural windows at the Texas plant. This includes considering potential opportunity costs that may arise from this decision, such as any negative impacts on existing orders or customer accounts. Additionally, the efficiency and effectiveness of the Texas plant’s performance in comparison to others in the industry, particularly its arch-rival plant in Oregon, is a point of concern. While both plants prioritize profitability, it is important to also consider the overall well-being of Pelarsen Windows as a whole. Therefore, determining whether increasing the architectural window business at the Texas plant aligns with the company’s overall goals is crucial. To begin this analysis, the cost data and operations of the Texas Plant will be re-evaluated using ABC, which offers clarity in understanding costs and serves as the foundation for many of the conclusions drawn.
Projected Income Statement for Texas Plant, Year-End 2008 Re-Computed using ABC
The following is the projected income statement for the Texas Plant re-calculated using activity drivers rather than production volume as a cost driver. As will be seen below, the cost to manufacture a single unit of the architectural windows is much greater than the standard window (note the negative contribution margin of the architectural windows).
The volume-based method, where standard windows were more expensive, contrasts with ABC. Under ABC, it is logical for architectural windows to be more expensive because they require more labor, material, and fixed resources compared to standard windows. ABC can accurately assign these costs by tracking activities to the correct product. The next section will delve deeper into each component of the income statement. We realize that the volume-based allocation approach distorts cost information, leading Doug to make uninformed decisions. As it stands now, architectural windows cannot make the Texas plant profitable.
Spoilage Rates Not Traced Properly
The projected 2008 income statement incorrectly combines all spoilage/waste into one pool and assigns this cost based on production volume. However, the spoilage percentage for wood and glass is significantly higher for the architectural windows compared to the standard window. Allocating these costs based solely on production volume does not make sense because the standard windows would end up absorbing the majority of these costs simply because they have been produced in higher quantities. The partial income statement below, prepared using ABC, correctly assigns wood and glass spoilage costs to the specific products that generate them. Both architectural and standard windows accurately reflect their respective spoilage rates. It is assumed that spoilage is an inherent cost in the manufacturing process and has been included in the per-unit costs for simplicity purposes. However, it may be beneficial to separate these costs if the company considers spoilage as an area for improvement and wants to visibly track them instead of including them as part of the direct material costs.
The 2008 projected income statement does not accurately reflect Direct Labor Costs because it fails to take into account the difference in process times between a standard window and an architectural window. This oversight results in labor costs being underestimated, as the additional time required to produce an architectural window is not accounted for. Conversely, the direct labor cost attributed to standard windows is overstated, as it subsidizes the production of architectural windows. Consequently, the labor costs incurred by architectural windows are primarily being borne by standard windows. To address this issue, an Activity-Based Costing (ABC) calculation has been performed, considering process times, skill levels, and hourly labor costs per window. The assumption is that skilled workers are assigned to the more complex architectural windows, while helpers work on simpler windows.
The ABC calculation reveals that architectural windows account for 65% of all direct labor costs, while the previous volume-based approach had estimated it to be 15.6%. This indicates that the previous calculation significantly underestimated the direct labor costs associated with architectural windows. The implementation of ABC methodology acknowledges that architectural windows require more skilled labor and additional time for manufacturing, thus justifying the higher labor costs. Consequently, the utilization of ABC allows for accurate computation of variable overhead based on the revised labor hours.
The labor hours required for replacing broken glass in the architectural window line should not be attributed to the standard window. The current method of calculating direct labor does not differentiate between products that require re-work and those that do not. Consequently, all labor costs are grouped together and allocated based on production volume. This leads to the standard windows bearing the brunt of these costs, even though they should not incur any. The table below illustrates that the cost of glass replacement is a distinct expense and should not be included in the standard window’s cost per minute calculation.
Fixed Overhead Costs Improperly Calculated
The allocation of fixed overhead costs based on production volume should not apply to architectural windows. This is because architectural windows require more process activities and should therefore bear a greater proportion of costs. The allocation of fixed costs to each window type is determined by specific activity drivers and their proportional distribution.
Next, the fixed costs per activity unit are calculated.
Fixed costs are allocated to architectural and standard windows based on activity usage per process, per window in the final step.
The observation here is that the architectural windows necessitate a greater number of activity “units” for production. As a result, it incurs its rightful portion of fixed costs, as shown above.
Marketing and G&A Improperly Calculated
Similar to the previous reasons, Marketing and G&A should be recalculated using activity drivers instead of volume:
Summary: Volume-Based Versus Activity-Based Cost Allocation
The current costing system allocates all costs based on the number of windows produced, resulting in higher costs for standard windows and lower costs for architectural windows. However, this does not take into account the increased costs associated with more complex products. The simpler standard window incurs higher costs in proportion to production volume, but volume alone does not determine the causal relationship to costs. The allocation of costs based on activities is a fairer method. With Activity-Based Costing (ABC), architectural windows will be assigned their fair share of costs, and standard windows will no longer bear the costs that they do not actually incur. Upon using ABC, it is realized that architectural windows are not as profitable as previously believed. The cost per unit calculation shows that architectural windows yield a loss of -$102.80, which is 258% less than the previous calculation of a $162 contribution margin. In contrast, the profit margin on standard windows is 43% higher than the volume-based approach, at $73.98 per unit.The standard windows were clearly providing financial support to the architectural windows by taking on a significant portion of its expenses. By using activity-based drivers to recalculate costs, a more accurate financial outlook for 2008 is presented.
Production Capacity of Architectural and Standard Windows – Texas Plant
Examining the production capacity of the Texas plant is important to determine if producing 270,000 standard windows and 50,000 architectural windows in 2008 is possible. The following tables assess the Texas plant’s capacity for standard and architectural windows separately.
The grey-shaded cell represents the daily production capacity on five production lines. The concept is that the production speed is determined by the slowest process, which is inserting glass for standard windows and cutting and shaving for architectural windows. This analysis assumes that there will always be units available from the previous day for each process. Therefore, each processing area has a total of 450 minutes of production time per day. Initially, there is a bottleneck for both architectural and standard windows at the first two process steps: cutting & shaving and forming. For standard windows, cutting & shaving takes 56 minutes per batch and forming takes 61 minutes per batch. Subsequent processes have to wait for these two processes to finish before they can process a single unit, which theoretically takes 1.91 hours (56 min + 61 min). It is assumed that units are available from previous days, weeks, years, etc. If we change the variables to allocate three lines to standard windows and two lines to architectural windows (3:1), the result is shown in the second table. Note: # of Windows Per day = number of windows per day in the grey-shaded cells above * x/5 production lines) Based on the first table, dedicating three lines to standard windows and two lines to architectural windows results in an excess capacity of 33,077 units for architectural windows and a shortage of 7,013 units for standard windows.The second table showcases a shift towards four standard lines and one architectural line, with a surplus capacity of 80,649 and a deficit of 8,462, correspondingly.
The analysis concludes that the proposed product mix of 270,000 standard windows and 50,000 architectural windows will not work as efficiently and effectively as planned. Whether one or two lines are dedicated to architectural windows, there will always be a shortage of one window over the other. Therefore, the opportunity cost of lost business must be considered if this product mix is required. This cost could be even greater if a single customer requires both standard and architectural windows and will only place an order if they can get both from the same vendor. Additionally, the Texas plant may lose its ability to prioritize specialized orders and thus lose its competitive advantage in the eyes of the sales team. It is important to note that this analysis assumes a 100% utilization rate, whereas management prefers 85%-90%. In reality, this rate may be even lower due to factors such as sickness, low productivity, and learning curves among employees, or plant-related issues like new processes, breakdowns, or maintenance. Realistically, dedicating at least one line to architectural production would result in shortages and losses exceeding 10-15% (100% minus 85%-90% utilization rate) compared to the figures presented above. The following computation outlines the production capacity of the Oregon plant for both standard and architectural windows combined.The table below displays the production time percentages for the Oregon plant in comparison to Texas. It reveals that Oregon can manufacture a standard window in 12% of the time it takes Texas, and an architectural window in 7% of the time. Nevertheless, Texas compensates for this discrepancy by having five concurrent production lines, whereas Oregon only has one.
This analysis provides further information about Doug’s proposed product mix for the Oregon plant. The plant is expected to produce 310,000 units, but it will only be able to manufacture 270,000 units. If the proposed product mix is followed, the financial statements would need to be adjusted to account for the 40,000 unit shortfall. It is assumed that the lower margin standard window business would be neglected in this scenario.
Additionally, reducing standard windows by 40,000 units would result in the following updated income statement and its impact on accounting profit.
The fixed costs for the standard window may decrease proportionately due to the 40,000 unit decline. However, if the cost driver is based on a measure that is stationary of units produced (such as supervision or headcount), the fixed costs would likely stay the same. Regardless, the accounting profit for standard windows is much lower compared to the architectural window business, and it may not be worthwhile for the Oregon plant to continue producing them. As a conservative assumption, we assume that fixed costs do not fluctuate based on the volume of standard windows produced. However, as the fixed costs exceed the contribution margin, it is no longer profitable for Oregon to produce standard windows. This was likely not Doug’s intention as he hoped for a decrease in standard window production and an increase in architectural windows. It’s important to note that this analysis assumes a 100% utilization rate, but losses are expected to be higher with an 85%-90% utilization rate. Nonetheless, the conclusion remains the same – producing standard windows would result in losses for Oregon based on the proposed product mix.
Considering Quality Costs for the Texas Plant
Below is a graph that shows the data of 80 units of standard and architectural windows.
The graph clearly shows that the architectural windows deviate significantly from the ideal specification point (represented by the yellow line). Many units also come close to exceeding the upper and lower control limits. In contrast, the process for standard windows is more tightly controlled, resulting in lower prevention and appraisal costs. For standard windows, it is assumed that internal failure is 3% and there is no external failure since broken glass does not need to be replaced at the customer site.
On the other hand, the architectural window requires significant prevention and appraisal costs as many units approach the upper and lower control limits. Internal failure is approximately 15% due to glass breakage, and external failure can be estimated at about 12% based on the rate of glass breakage at customer sites. Increasing production of the architectural window will therefore increase its quality costs, including preventative, appraisal, internal, and external expenses. This could also potentially affect the standard window line if employees are dedicating more time to quality checks for the architectural window and neglecting the standard window.
In addition to quantifiable costs, non-quantitative factors should also be considered. These include Texas’ reputation for high quality and low returns being affected, potential customer dissatisfaction, and potential loss of combined sales contracts that also impact the standard window line.
Conclusions
Based on the analysis above, it is evident that Texas should not produce architectural windows. Producing these windows is costly and leads to a negative contribution margin, ultimately impacting the plant’s bottom line. Additionally, switching any of the production lines to architectural windows would result in production shortages and further losses. The production of more architectural windows would also entail higher quality costs due to increased spoilage and labor hours. This goes against Doug’s commitment to maintaining high quality within the Pelarsen plant network. Hence, it can be assumed that the introduction of more architectural window business would significantly raise quality costs and adversely affect Doug’s reputation. Furthermore, allocating standard to architectural windows would cause the Oregon plant to suffer production capacity shortages and incur losses. Consequently, the fixed costs at Oregon would exceed the contribution margin for standard windows, eliminating any financial incentive to continue producing them. Considering the financial position of both Texas and Oregon plants, it is clear that the proposed product mix does not align with the overall objectives of the company.The consequences of Doug’s proposed allocation include losses at the Texas plant, declining profits at Oregon, shortages in production capacity, customer dissatisfaction, potential hostility between plant managers, and misalignment of company goals. One possible solution, which is better than Doug’s proposal, involves specializing in different window types for each plant. This means that the Texas plant would focus on Standard Windows and the Oregon plant would focus on Architectural Windows. If both plants specialize in one window type, the financial statements would show profitability for both plants.
The Texas plant can now only employ helpers, reducing the labor rate from $34 to $18. There are no changes in fixed production overhead, marketing, and G&A costs following the restructure of product mix (further cost savings are likely but have not been assumed). Capital charge also remains unchanged. The proposed mix is preferred for the following reasons:
The Oregon plant is economically efficient for producing architectural windows due to its ability to create them in less time and with fewer resources. Conversely, the Texas plant consumes excessive labor, time, and resources when producing architectural windows, resulting in no profits. Despite this, both plants still have additional capacity available. This is advantageous as it is not realistic to have 100% capacity utilization. Furthermore, having excess capacity at the Texas plant allows the sales teams to prioritize specialized orders and expedite their production.
- Texas Plant (windows per year)
- Production Capacity: 438,250
- Proposed Production of Windows: 400,000
- Excess Capacity: 38,250
- Capacity Utilization % 91.3%
- Oregon Plant (windows per year)
- Production Capacity: 270,000
- Proposed Production of Windows: 230,000
- Excess Capacity 40,000
- Capacity Utilization % 85.2%
Both plants will generate a profit, with the Oregon plant exceeding the projected income statement. The Texas plant will have a profit of $17.8 million, representing a 1605% increase compared to the projected income statement. These results will contribute to the overall objectives of the Pelarsen organization and its individual profit centers. The goals of the company are aligned with those of its individuals.
Some Further Considerations
Despite the various assumptions made during the analysis, there are several additional considerations that should be noted:
Firstly, the income statements do not take into account the additional costs of distribution if each plant produces only one type of window. These costs have not been accounted for.
Secondly, the sales team will need to change their sales strategy as geographical proximity and available capacity can no longer be used as factors when allocating business. This change in strategy may incur additional costs.
Furthermore, if plants have clients who regularly purchase both types of windows from one plant, the inability to do so conveniently or a preference for purchasing locally may result in customer dissatisfaction and potentially further loss of revenue.
Lastly, the assumption that skilled workers are assigned to architectural windows and helpers are assigned to standard windows may need to be revised. If, for example, a window now requires an equal mix of skilled workers and helpers, Texas’ labor cost could change accordingly and lead to an overall profit on the income statement.
It is possible that the plants may discover that it is more advantageous to produce both types of windows for various reasons, such as proximity, existing contracts, and expected distribution costs. If labor is divided equally between the two types, the Texas plant will make a profit with a product mix of 270,000 architectural windows and 50,000 standard windows. However, if there is a deviation from the assumption of assigning skilled workers to architectural windows and helpers to standard windows, the conclusions will also change.
