Profitability Analysis â€Iâ€™m not looking forward to breaking the news,â€ groaned Charlie Wettle, the controller of Meyer Paint Company. He and Don Smith, state liaison for the firm, were returning from a meeting with representatives of the Virginia General Services Administration (GSA), the agency that administers bidding on state contracts. Charlie and Don had expected to get the specifications to bid on the traffic paint contract, soon to be renewed. Instead of picking up the bid sheets and renewing old friendships at the GSA, however, they were stunned to learn that Meyerâ€™s paint samples had performed poorly on the road test and the firm was not eligible to bid on the contract.
Meyerâ€™s two main product lines are traffic paint, used for painting yellow and white lines on highways, and commercial paints, sold through local retail outlets. The paint-production process is fairly simple. Raw materials are kept in the storage area that occupies approximately half of the plant space. Large tanks that resemble silos are used to store the latex that is the main ingredient in its paint. These tanks are located on the loading dock just outside the plant so that when a shipment of latex arrives, it can be pumped directly from the tank truck into these storage tanks. Latex is extremely sensitive to cold. It cannot be stored outside or even shipped in the winter without heated trucks, which are very expensive for a small firm such as Meyer.
Currently, Meyer has the traffic paint contracts for the states of Pennsylvania, North Carolina, Delaware, and Virginia. Of last yearâ€™s total production of 380,000 gallons, 90% was traffic paint. Of this amount, 88,000 gallons were for the Virginia contract. Each state has unique specifications for color, thickness, texture, drying time, and other characteristics of the paint. For example, paint sold to Pennsylvania must withstand heavy use of salt on roads during the winter. Paint for North Carolina highways must tolerate extended periods of intense heat during summer months.
Due to the high cost of shipping paint, most paint producers can be competitive on price only in locations fairly close to their production facilities. Accordingly, Meyer has enjoyed an advantage in bidding on contracts in the eastern states close to Virginia. However, one of its biggest competitors, Heron Paint Company of Houston, Texas, is building a new plant in North Carolina. With lower costs due to its efficient new facility and its proximity, Heron will become a major competitive threat.
Meyerâ€™s commercial paint line includes interior and exterior house paints in a wide range of colors formulated to approximate authentic colonial colors. Because of the historical association, the line has been well received in Virginia. Most of these paints are sold through paint and hardware stores as the storesâ€™ second or third line of paint. The large national firms such as Benjamin Moore or Sherwin Williams provide extensive services to paint retailers such as computerized color matching equipment. Partly because it lacks the resources to provide such amenities and partly because it has always considered the commercial paint a sideline, Meyer has never tried to market the commercial line aggressively. Meyer sells 38,000 gallons of commercial paint per year.
Charlie is worried about the future of the company. The firmâ€™s strategic goal is to provide a quality product at the lowest possible cost and in a timely fashion. After absorbing the shock of losing the Virginia contract, Charlie wondered whether the firm should consider increasing production of commercial paints to lessen the companyâ€™s dependence on traffic paint contracts. Carl Bunch, who manages the day-to-day operation of the firm, believes the company can double its sales of commercial paint if it undertakes a promotional campaign estimated to cost $120,000. The average price of traffic paint sold last year was $20 per gallon. For commercial paint, the average price was $24.
Charlie Wettle has assembled the following data to evaluate the financial performance of the two lines of paint. The primary raw material used in paint production is latex. The list price for latex is $32 per pound; 450 pounds of latex are needed to produce 1,000 gallons of traffic paint. Commercial paint requires 325 pounds of latex per 1,000 gallons of paint. In addition to the cost of the latex, other variable costs are as shown below.
TrafficCommercial Raw materials cost per gallon of paint: Camelcarb (limestone) $0.76 $1.08 Silica 0.74 1.04 Pigment 0.24 0.76 Other ingredients 0.12 0.06 Direct labor cost per gallon 0.92 1.70 Freight cost per gallon 1.56 0.86
Last year, fixed overhead costs attributable to the traffic paint totaled $170,000, including an estimated $50,000 of costs directly associated with the Virginia contract; the $50,000 can be eliminated in approximately two years. Fixed overhead costs attributable to the commercial paint are $26,000. Other fixed manufacturing overhead costs total $220,000. Charlie estimates that $80,000 of this amount is inventory-handling costs that will be avoided due to the loss of the Virginia contract. Both the remaining fixed manufacturing overhead ($140,000) and the general and administrative costs of $280,000 are allocated equally to all gallons of paint produced.
Calculate the contribution margin for each type of paint and total firmwide contribution under each of the following scenarios:
Scenario A Current production, including the Virginia contract
Scenario B Without either the Virginia contract or the promotion to expand sales of commercial paint
Scenario C Without the Virginia contract but with the promotion to expand sales of the commercial paint
Determine whether scenario B or C (per requirement 1 above) should be chosen by Meyer and explain why, including a consideration of the strategic context.
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