Product-Line Pruning at Meridian Cartons
Meridian Cartons runs one corrugator with 18,000 machine hours a year; current demand uses 17,400. Its three lines are Retail cartons, E-commerce mailers and Industrial wraps. Retail: sales $2.40m, direct materials $1.10m, direct labour $0.50m, variable overhead $0.20m, 6,000 hours, 2,400 orders and $120k of avoidable customer-specific design. E-commerce: sales $1.80m, materials $0.80m, labour $0.30m, variable overhead $0.15m, 4,200 hours, 7,800 orders and $40k design. Industrial: sales $3.00m, materials $1.50m, labour $0.70m, variable overhead $0.30m, 7,200 hours, 1,100 orders and $80k design. Fixed overhead is $1.20m, allocated by machine hours. The sales director proposes dropping Retail. She says the freed hours can add 4,000 E-commerce hours at existing margins and 1,500 Industrial hours, but the Industrial increment would need a 10% price discount. The CFO is sceptical because the plant would still carry idle capacity and the Retail customers also buy E-commerce lines.
1. Quantify the annual financial effect of dropping Retail and reallocating the hours as proposed. Use relevant costing and contribution per constrained hour, and state any assumption about avoidable costs.
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Contribution before allocated fixed overhead: Retail $2.40m - $1.10m - $0.50m - $0.20m = $0.60m, or $100 per machine hour. E-commerce $1.80m - $0.80m - $0.30m - $0.15m = $0.55m, or $130.95 per hour. Industrial $3.00m - $1.50m - $0.70m - $0.30m = $0.50m, or $69.44 per hour. The $1.20m fixed overhead is not relevant unless it is cash-avoidable; allocating it by machine hours merely makes Retail look weaker. Dropping Retail loses $0.60m contribution but saves $120k avoidable design cost, so the net avoidable loss is $480k. The proposed reallocation gains 4,000 x $130.95 = $523.8k from E-commerce. Industrial incremental revenue per hour is $3.00m / 7,200 = $416.67; a 10% discount reduces contribution by $41.67 per hour, leaving $69.44 - $41.67 = $27.78 per hour. For 1,500 hours this is $41.7k. Total gain is $565.5k, so net effect is $565.5k - $480k = +$85.5k before any incremental order-handling or design cost. The plant would have 1,100 idle hours after the change (600 existing plus 6,000 freed less 5,500 used), so the proposal does not fully use capacity. The conclusion is positive but thin; incremental order costs, design costs and demand certainty must be confirmed.
2. Explain why the allocated fixed overhead could make Retail look unprofitable and how an activity-based view of order handling and design would refine the decision. Include one qualitative factor that could reverse the recommendation.
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The traditional allocation charges Retail $1.20m x 6,000/17,400 = $413.8k of fixed overhead, although Retail may not cause that cost. After allocation, Retail profit is only $186.2k, while E-commerce shows $336.2k and Industrial $86.2k. That ranking is an artifact of using machine hours as the allocation base. An activity-based view would assign order-handling cost by orders and design cost by design events. Retail has only 2,400 orders against E-commerce's 7,800, so Retail is likely overcharged by a volume-based order allocation; however, Retail carries $120k of avoidable design cost. The ABC view would show the net cost to serve each line and could change the ranking again. A qualitative factor that could reverse the decision is that Retail customers also buy E-commerce lines; dropping Retail may reduce E-commerce demand or weaken the plant's bargaining position with suppliers. Other reversing factors include loss of a stable base that covers fixed costs, competitor entry, workforce skills, and customer lifetime value.
3. The sales director wants approval today. What additional information or conditions would you require before accepting the reallocation?
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I would require evidence of external demand for the additional E-commerce and Industrial volumes, not just internal sales optimism. I would ask for the incremental order-handling, design, freight and inventory costs, because these can consume the $85.5k margin. I would confirm whether any fixed overhead, supervision or machine costs are genuinely avoidable if Retail is dropped. I would check whether the Industrial 10% discount applies only to the incremental units or to all Industrial volume, and whether competitors will respond. I would test cannibalisation: Retail customers may buy E-commerce products, so lost Retail sales may also reduce E-commerce contribution. I would review capacity reliability, labour skills, supplier terms and the 1,100 idle hours. Finally, I would set a review period and require a sensitivity analysis showing the proposal under lower incremental demand and higher design costs.