Colin Drury, Management and Cost Accounting – Reichard Maschinen GmbH

Reichard Maschinen, GmbH

Teaching note
Professor John Shank*, The Amos Tuck School of Business Administration
Dartmouth College
* This teaching commentary was prepared by Professor John K. Shank of the Amos Tuck School of
Business. This teaching note includes ideas and insights from previous teaching notes by Ed Barrett
and Dick Vancil for this case. This case was originally set in the mid 1970's but all the references have
been updated to 2000. The quantities and prices have not been updated from the 1970's.

OVERVIEW

This case deals with cost analysis for assessing the economics of a product transition facing Reichard
Maschinen, but it also involves the broader spectrum of business issues related to the transition. At
one level, the economics of the situation need to be brought into focus; fixed costs, marginal costs,
and sunk costs must be separated and evaluated for their "relevance" to the decision. At another level,
when the marketing and manufacturing issues are considered, the complexity of the decision becomes

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apparent. Financial signals say that steel rings are more profitable; marketing signals say that the

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future belongs to plastic rings; manufacturing signals say we should perhaps "buy" rather than "make".

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The main dilemma of the case is "How long can the firm stay with the substantially more profitable, but

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technologically obsolete, steel rings while still holding to its strategy of being a top quality producer at
a fair price?"

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The case is a very good classroom vehicle for illustrating several different layers of sophistication in
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terms of relevant cost analysis. The following issues and concepts are likely to arise during classroom
discussion.

1. The concept of eliminating applied fixed overhead in a short run, relevant cost analysis.
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2. The concept of sunk costs in a relevant cost analysis.

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3. The concept of the "product substitution" aspects of contribution analysis.

4. The use of the above analysis as a numerical framework for a partial view of the pricing
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decision.
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This case teaches very well early in the required managerial accounting course in the first year of the
MBA program. This case can be comprehensively covered in one 90-minute class period.

CASE ANALYSIS
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Before actually going through the assignment questions in the case, the instructor may wish to refer
students to Exhibit 1 in the case which shows the inventory related to steel rings. The important point
here is that there is enough inventory to supply customers with steel rings for the next 87 weeks; make
sure students understand this summary.
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ANSWERS TO ASSIGNMENT QUESTIONS

Question 1

This question asks for the differential cost to produce 100 plastic rings. The relevant cost calculations
are tabulated in Table 1. As shown in this table, the variable or incremental cost of producing 100
plastic rings is $32.28. This is the incremental cost of producing the second 100 rings. Reichard must
first invest $10,000 in tooling and pay any other expense associated with adding plastic rings to the
product line of the plastics department. Once these modest start-up costs are "sunk", the differential
or incremental costs to produce 100 plastic rings is $32.28.

Question 2

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 Colin Drury, Management and Cost Accounting – Reichard Maschinen GmbH

This question asks for the incremental cost to produce the next 34,500 steel rings (see Table 1). The
firm already has the raw material to produce 34,500 steel rings. The special steel used in the
manufacture of the rings has already been purchased and there is no alternative market for the raw
steel. Since the scrap value of the steel used to make the rings is zero, the opportunity cost of the raw
material is also zero. Thus, there is no further raw material cost, explicit or implicit, involved in the use
of the raw steel to produce rings.

The labor cost for manufacturing steel rings this summer also involves some analysis. It can be
argued that the incremental cost of direct labor is only 30% of the normal labor rate, because of the
company's labor policy. Under its policy of maintaining full employment through slack production
periods, the company pays its workers 70% wages to do "make work" projects. The numbers in Table
1 assume that these projects have no real value to the company. The incremental cost of shifting
workers from some project to ring production would just be the increase to full wages, which amounts
to 30% of the normal wage rate. The variable overhead, due largely to fringe benefits related to direct
labor, normally amounts to about 80% of the incremental labor cost. The incremental variable
overhead cost will also be 30% of normal. As shown in Table 1, the incremental cost per 100 rings to
produce the next 34,500 steel rings over the summer is $25.27.

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Question 3

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This question asks for the differential cost of the 25,450 steel rings which already are in inventory at

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the end of May. The idea here is to see that the 25,450 finished steel rings already in inventory have
zero differential cost. No additional work needs to be done on these rings. Even though they carry a

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value of $263.85 (per 100 rings) in inventory, there will be no additional expenditure to sell the rings.
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Question 4

This question asks which ring is more profitable, steel or plastic. Another layer of complexity is added
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here because of the unequal lives of the steel and plastic rings. If the plastic ring has about four times
the life of the steel ring, the market demand (in units) for the plastic rings is likely to be significantly
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less than the demand that currently exists for the steel rings. If the firm switches to plastic rings but
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does not increase its market share, it can expect to sell only 25% as many rings as it does now.

The relevant cost and profit calculations for the steel and plastic rings are contained in Table 2. For
purpose of this analysis, we first assume current selling price for steel rings and plastic rings.
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Implications of relaxing this assumption are discussed later. Profitability of plastic and steel rings can
be compared for four scenarios: (1) plastic rings vs. 25,450 steel rings in stock; (2) plastic rings vs. the
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next 34,500 steel rings that can be produced over the summer; (3) plastic rings vs. any future steel
rings using "contribution analysis"; (4) plastic rings vs. any future steel rings using "full cost analysis".

Plastic rings vs. the 25,450 steel rings in stock. When plastic rings are compared to the 25,450
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steel rings now in inventory, the steel rings are far more profitable because their marginal cost is zero.
Any revenue gained from their sale is incremental profit contribution at this point. Assuming current
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sale prices of $325/$340 per hundred for steel rings and plastic rings, the profit contribution from the
existing steel rings would be $82,713 ($325 x 25,450/100) compared with $19,598 from the plastic
rings ($308 x 6,363/100). The students should see that it is clearly much more profitable to sell the
existing steel rings than to manufacture and sell any plastic rings in their place.
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Plastic rings vs. the next 34,500 steel rings that can be produced over the summer. The
students can determine that the 34,500 steel rings which could be produced this summer from the raw
material on hand will yield a profit contribution of $103,500 ($300 x 34,500/100). The corresponding
number of plastic rings which would fill the same customer demand is 8,625. Their total profit
contribution would be $26,565 ($308 x 8,625/100) if the rings were also sold for $340 per hundred.
Therefore, the steel rings which could be produced over the summer are also far more profitable than
plastic rings.

Plastic rings vs. future steel rings using "contribution analysis". On a marginal cost basis, the
steel rings will bring a marginal contribution of $164 per hundred rings. With a yearly volume of 35,880
(690 per week x 52 weeks), steel rings contribute $58,883. Correspondingly, with a yearly volume of

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 Colin Drury, Management and Cost Accounting – Reichard Maschinen GmbH

8,970, the plastic rings would contribute $27,628 ($308 x 8,970/100). This would suggest, using
marginal contribution criteria, that the steel rings are more profitable, even in the longer run. But
marginal contribution analysis loses its usefulness when considering the long term. What happens
under a full cost analysis?

Plastic rings vs. future steel rings using "full cost analysis". On a full cost basis, steel rings have
a profit of $61.15 per hundred when sold for $325. A yearly volume of 35,880 produces a profit of
$21,941. Plastic rings have a profit of $273.40 per hundred. A yearly volume of 8,970 would bring a
profit of $24,524. Thus, on a full cost basis, the plastic ring is more profitable with current pricing. But
one big problem with this analysis is the assumption that market prices remain unchanged in the long
run. Students will argue, with justification, that prices will change over time. The instructor can ask a
student what price relationship is likely to prevail between the steel rings and the plastic rings once
plastic become widespread. Students will recognize that the price relationship that will evolve between
plastic rings and steel is a critical variable on which the final decision will hinge. This and other
business issues are considered in detail in discussing questions 5 and 6.

At some stage during the discussion of the comparative profitability of the two types of rings, the
instructor should make certain students consider how much fixed overhead each ring absorbs. With a
current yearly production volume of 35,880 units, the steel rings absorb about $37,000 of fixed

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overhead costs per year ($1.03 per unit x 35,880 units = about $37,000).

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With a production volume of 8,970 units, the plastic rings will only absorb about $3,100 of fixed

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overhead costs per year ($.35 per unit x 8,970 units = about $3,100).

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It is important for students to realize that the excess fixed overhead expenses will very likely not go
away - they will be transferred to other products, at least in the short run. In the same sense, plastic
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ring production will require only about 10% of the direct labor that steel ring production now does. Can
the excess labor be used to manufacture some other product? Of course, steel rings only use about
the equivalent of 2 workers a year now (358 x 46.80 = $16,800 = about 2 persons). Thus, the ability of
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the plant to absorb the displaced labor is not in much doubt.

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Question 5
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1. Stay with steel only.

Business as usual. The firm could tell its customers right away that an "experimental" plastic
ring is also available now in some markets. They could say that Reichard does not see the
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merits of plastic replacement parts, but some people do. If the customer wants to risk their
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machines with plastic components, that is certainly their option. Of course, the machinery
warranty does not apply in that case.

2. Move to plastic only - Get ready to make plastic rings as soon as possible.
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A. Right away - Stop producing steel rings now. Throw away the existing
inventory of raw material. Sell from the existing inventory of finished rings only
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until plastic rings can be supplied. Then, throw away the remaining steel rings.
B. Gradually - Convert the existing raw materials to steel rings this summer Don't
buy anymore raw steel. Sell both steel and plastic over the next one to two
years until the supply of steel rings is exhausted. Then make and sell plastic
only. (Comparative pricing of steel and plastic is a big issue here.)
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C. Later - Introduce plastic only after the full inventory of steel is exhausted.

3. Offer both plastic and steel as a long-run option for customers. Manufacture and sell both
plastic and steel for the foreseeable future. (Comparative pricing?)

4. Get out of the business of supplying replacement rings. (Make vs. Buy)
The instructor should note that the purpose of the financial analysis is to help decide which of
these alternatives seems best for the firm.

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 Colin Drury, Management and Cost Accounting – Reichard Maschinen GmbH

Question 6

As discussed earlier, the financial analysis in Table 2 yields the following conclusions:

1. For the next 25,450 rings, steel rings are much more profitable than plastic rings.

2. For the next 34,500 rings after that, steel rings are still much more profitable than plastic rings.

3. For all rings beyond 59,950 units:

Steel rings are more profitable than plastic on a marginal contribution basis but plastic rings are more
profitable than steel on a full cost basis.

The above inferences, based on incremental financial analysis need to be blended with marketing,
manufacturing, and strategic considerations before reaching a final decision. Some of the
considerations are as follows:

1. Will the price of steel rings hold at $325 once plastic rings are introduced widely into the

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market?

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2. Will the price of steel rings fall to one-fourth of the price of plastic rings, or will plastic ring

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prices rise?

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3. What effects will the decision in respect to plastic rings have on the sale of machines?
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4. Can the plastic rings be sold in Belgium without impacting the other markets? Given the free
flow of goods and information within EC, how can the company sell plastic rings in one country
only without affecting other EC markets?
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5. Should the firm exert its leadership in markets other than Belgium by being the first to
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introduce plastic rings? How much "strategic" value is there in being the "first mover" in other
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markets?

6. How long is it prudent to continue to try to sell a short-lived, highly profitable replacement part
(steel rings) without jeopardizing the company's reputation and image as a leader in its field?
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To introduce discussion on these issues, the instructor can focus on two key topics: (1) the
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uncertainties surrounding the relative price of plastic and steel, and (2) the time frame over which the
customer is likely to switch from steel to plastic.

Uncertainties regarding steel and plastic ring prices. In the financial analysis shown in Table 2, we
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assumed that the steel and plastic rings will sell for the current prices ($325 and $340). Students are
likely to suggest several different scenarios for future prices of plastic and steel rings.
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1. Given that plastic has four times the wearing properties as steel rings, one might argue that
the "value" price for plastic rings would be $1,300 ($325 x 4). This scenario is highly unlikely
for several reasons: (a) the full cost of producing plastic rings is only $67; (b) the "barriers to
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entry" into the plastic ring market are low for firms in the plastics (injection molding?) business;
(c) competition in the market is already fairly strong with Japanese manufacturers entering the
field offering lower priced spare parts.

2. All of these factors suggest that, in the long run, the market price for plastic rings will probably
be the cost of production plus some "normal" mark-up. One estimate for the long-run price for
the plastic rings under this scenario would be about $81 based on a full cost of $67. This
would give manufacturers a profit margin of about 18% ($14/$81) - the same profit margin as
now with the steel rings ($61/$325).

Of course, the manufacturing cost for plastic rings in a plastics firm with lower labor costs and
overhead than Germany could well be much lower than $67.

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 Colin Drury, Management and Cost Accounting – Reichard Maschinen GmbH

3. Once customers are convinced that the plastic ring does in fact last four times as long, will
they pay more than 1/4th as much for steel rings? If plastic rings sell for $81 or less, does this
suggest that the price of steel rings will drop to about $20?

How soon will the market switch over to plastic rings? One factor which mitigates against a quick
changeover is the concept of "barriers to switching". There are some businesses with high entry
barriers and low switching costs ("light bulbs"), and other businesses where the entry barriers are low
but switching costs for the customers are high ("steel/plastic rings").

The barriers to entry in the light bulbs business are high because of the technology, the large capital
investment, and the substantial start up time. However, the switching costs across different brands of
light bulbs are low for most consumers (all light bulbs are basically the same). Further, the chances of
damaging a lamp are minimal in switching from one light bulb brand to another.

As noted earlier, the "barriers to entry" in the plastic ring market are probably low. However, there are
very high "barriers to switching" in this situation. There is a great apparent difference between steel
rings and plastic rings. If plastic rings are used and there are equipment problems, the company

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stands to lose far more than what it saves on rings. With 24 rings per year, the steel ring cost is $6 per

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month on a $6,000 machine. In other words, the potential for damage to machines by using plastic
rings may not be worth the savings.

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Many machine owners will be hesitant to convert to plastic rings until they are certain no damage will

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be done to their machines. The savings are just too small to be a big deal.
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This means that Reichard can have some influence over the rate of switching from steel to plastic.
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They can keep growth slow if they offer both types of rings to customers but emphasize the
"experimental" nature of plastic. This might allow the firm to potentially sell all their existing steel rings
and the ones they can produce over the summer during the transition period. In the preceding
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analysis, this has already been shown to be "financially attractive".

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Over time, however, given the much lower cost and the much longer life of plastic rings, they should
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gain nearly the entire market. Therefore, the question of which product is more profitable in the long
run should be obvious to the students.

The instructor should also ask, however, whether the firm was better off selling steel rings in the past
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than it will be in the future selling plastic rings? If we assume that market forces will drive the profit
margin of plastic rings to that of steel rings now (18%), then the firm will clearly be worse off. The
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market for replacement rings will shrink by 75%. Because of this technological product improvement,
replacement rings will become a less attractive market in the future for all manufacturers. The
instructor can further expand on this idea by referring students to Table 3. Here, we have shown that
steel rings generate a much greater annual contribution than plastic rings. As such, plastic rings are
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not nearly as attractive.

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The students will see that, financially, Reichard has the incentive to forestall the market's move toward
plastic rings. Perhaps the firm could forestall this move, but at what cost? It may have to lower the
price of its steel rings to avoid losing market share. Marketing wisdom might argue for the immediate
switch to plastic rings in order to keep the trust and loyalty of the customers. It is interesting to note
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that the sales manager is the most enthusiastic proponent for the immediate switch to plastic rings.
His attitude may be motivated by a simple desire to offer the best value to his customers, although he
offers some spurious profitability arguments to support his position. It is useful for students to see that
his financial analysis is confused and faulty.

RECOMMENDATIONS

At this stage of the analysis, the instructor should turn to recommendations. What should the firm do?
There are a variety of "defensible" solutions to the case. The following ones are those we like to make
certain are brought out in the classroom discussion.

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 Colin Drury, Management and Cost Accounting – Reichard Maschinen GmbH

1. Sell the 25,450 steel rings that are currently in stock. If the firm can sell them for at least $77
per hundred (hopefully more!), the incremental contribution is more than the contribution on
plastic rings.

2. Convert the raw steel inventory into rings during the summer using the excess labor. If the firm
can sell the steel rings for at least $102, the contribution would be $77, which equals that from
plastic rings.

3. Do not buy any more steel.

4. Tell our customers immediately about the new "experimental" plastic rings which are available
in some markets.

5. Whether the firm should gear up to produce plastic rings is highly debatable. Table 4 makes
the case for buying the rings instead of making them. It is worth noting that it would be much
easier to hold the price on steel if we are not selling plastic at the same time. We can just tell
customers they can try plastic, if they want to take the risk.

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Assuming Reichard converts its raw steel into rings, how can they manage the market transition from

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steel to plastic in such way as to protect their market share and image as a high-quality, innovative

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firm while maximising short-run profits from the sale of steel rings? Herein lies the really tough

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management issue. Is it worth trying to stretch out the transition period by relying on the high switching
barriers? If one sees this as "cheating" on the customer, and thus proposes "full speed ahead" to

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plastic, what about the lost short-run profit? Would your answer be the same if we added three zeros
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to all the numbers?
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As an aside, much of the problem stems from the heavy inventory investment which was probably
motivated by quantity discounts in purchasing and cost efficiency from long production runs. The
resulting reduced flexibility to respond to market changes has a very real cost here, but it does not
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show up directly in the accounting reports. The value of "flexibility" is real and perhaps deserves as
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much attention, in many situations as the value of "efficiency".

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CLASSROOM STRATEGY

In teaching this case, we recommend going through the questions, one by one. Try to save at least 15
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to 20 minutes for the classic question - what should management do and why? During the discussion
the quantitative questions should be woven into the rationales for various decision options. The
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instructor's job is to keep the discussion moving and make sure all the twists and turns are brought
out.

There is no "right" answer in the end, and we recommend closing with the rhetorical question that is
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asked in the Introduction section: "How long can the firm stay with the substantially more profitable,
but technologically obsolete, steel ring while still holding to its strategy of being a top quality producer
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at a fair price?"

TABLE 1
Relevant Costs
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(per 100 units

Steel Rings
25,450 Rings Summer Production Future Rings
in stock (next 34,500 rings) Full Cost Variable Cost
Raw Materials $0.00 $0.00 $76.65 $76.65
Direct Labor 0.00 14.04 46.80 46.80
Variable OH 0.00 11.23 37.44 37.44
Fixed OH 0.00 0.00 102.96 0.00

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 Colin Drury, Management and Cost Accounting – Reichard Maschinen GmbH

Total $0.00 $25.27 $263.85 $160.89

Plastic Rings
Full Cost Variable Cost
Raw Materials $4.20 $4.20
Direct Labor 15.60 15.60
Variable OH 12.48 12.48
Fixed OH 34.32 0.00
Total $66.60 $32.28

Notes:
1.Assume that the "make work" projects have zero real value to the company.
2.The variable overhead is 40% of the departmental overhead or .8 x direct labor.

TABLE 2
Comparison of Incremental Profitability

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Steel Rings

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25,450 Rings in stock Next 34,500 Rings Future Rings

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Contribution Full Cost

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Revenue rs e $325.00 $325.00 $325.00 $325.00
RM --- --- 76.65 76.65
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Labor --- 14.04 46.80 46.80
OH: Dept. --- 11.23 37.44 93.60
Admin. --- --- --- 46.80
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0 25.27 160.89 263.85

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Profit $325.00 $299.73 $164.11 $61.15

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x4 x4 x4 x4
= $1300.00 $1199.00 $656.00 $245.00
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Plastic Rings
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"Contribution" "Full Cost"

Analysis Profits
Revenue $340.00 $340.00
RM $4.20 $4.20
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DL 15.60 15.60
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OH: Dept. 12.48 31.20

Admin. --- 15.60
$32.28 $66.60
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Profit Contribution $307.72 $273.40

TABLE 3
Annual Contribution of Plastic and Steel Rings

In the Future Now

Item Plastic Steel

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 Colin Drury, Management and Cost Accounting – Reichard Maschinen GmbH

Sales Price ~$80.00 $325.00

Variable Costs:
Material $4.20 $76.65
Direct Labor 15.60 46.80
Overhead (40%) 12.48 37.44
$32.28 $160.89
Contribution ~$48.00 $164.11
2 1
Unit Sales 8,970 35,880
Annual Contribution ~$4,320 $58,883

Notes:
1. The firm currently sells 35,880 rings per year (690 x 52).
2. If all sales switch to plastic rings, the steady state volume would be 8,970 (1/4 x 35,880).

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TABLE 4

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Make Rings (A low value replacement part) vs. Buy Rings

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How would you think about this problem?

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We sell about 36,000 rings/year
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If we assume we have ~10% SOM, per the case

World Market = 360,000 steel rings

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With Plastic = 90,000 (÷4) plastic rings

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Plastic Price (within 1 year) $80 (or less)

The cost leader is now likely to be a plastics company and cost will be the key to price

World Market = 90,000 x $80/100 = $72,000 = Tiny! (We sell $112,000 in rings now)
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Leave this business to the plastics companies (small firms). We can buy easily

IS THIS "GOOD THINKING"?

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