AirWrap Packaging, Inc This Good Opportunity For Air wrap 45 Discount

AirWrap Packaging, Inc.

Teaching Commentary

OVERVIEW

This is a very challenging case that gives students practice in customer value analysis, product costing, full cost

versus marginal cost analysis, “capacity costing,” and product line profitability. For students who are up to the

challenge, it makes an excellent end–of-term review case or final exam. I have used it successfully in both contexts

ANSWERS TO ASSIGNMENT QUESTIONS

Questions 1 and 2 deal with profitability analysis for the base product (Air Seal), with accounting for

excess capacity thrown in. Question 3 covers the break–even point and the issue of “operating leverage.” Questions 4

through 7 deal with LCC for four different product situations drawn from the four cells in the LCC matrix in the

Question 1

(a) What is the Return on Investment (ROI) for AirSeal for 1985?

Profit = $9.3 million, per Exhibit 1 in the case

Investment

A/R

(45 DSO)

= $ 4.3 million

(4 Turns)

= $ 4.6 million

Gross Equipment Cost

($2.6 x 1/2 x 20)

ROI = Profit / Investment = 9.3 / 34.9 = 26.7% (before tax)

(b) How is the AirSeal product line doing, using the “DuPont formula?”

2-2

Question 2

How would the ROI change if excess capacity (Fixed Manufacturing Overhead, Factory Labor, and

Manufacturing Equipment) were not charged to the product line?

1985 volume = 721 million sf

Question 3

(a) Calculate the break-even sales volume in dollars for AirSeal in 1985.

Contribution Margin

= Sales – RM – VOH – Freight – Commissions (at 2% of Sales)

= $34.8 – $3.9 – $1.4 – $3.1 – $.7

= $25.7

Fixed Cost

= Factory Labor + Fixed Overhead + Other Expenses (less Commissions)

Fixed Cost

= $10.4 + $2.6 + $4.1 – $.7

= $16.4

= Fixed Cost  CM% of Sales = $16.4 /.74

B/E as % of Capacity

= 22.2/ 46.4 = 48%

which is pretty low.

Fixed Costs

= $16.4 million = 35% of Capacity Sales

(b) Discuss the “Operating Leverage.”

AirSeal is a high contribution margin, high fixed cost business, which means it has a high degree of

operating leverage.

Question 4

(a) Calculate the LCC to Noritake per shipment for AirSeal and AirWrap.

(b) Based on part (a), what is the market potential of AirWrap for this customer?

Part (a)

Life Cycle Cost (LCC)

AirSeal

AirWrap

Other Shipping

Total Shipping

2-3

Part (b) The “Value Proposition” for AirWrap (comparative LCC)

Question 5

(a) Calculate the LCC for NEW per-shipment for AirSeal and AirWrap.

(b) Based on part (a), what is the market potential for AirWrap for this customer?

Part (a)

Life Cycle Cost (LCC)

AirSeal

AirWrap

Packing material

$ 0.581

$ 0.322

Other shipping costs

Part (b)

The “Value Proposition” for AirWrap = $20.87 — $20.61 = $0.26.

An uncoated bubble is the better choice for this application, which falls into Cell II.

Question 6

(a) Calculate the LCC per shipment for FAP for Air Cap, AirWrap, and “Loose Peanuts,” using the data

from the case.

2-4

Part (a)

Life Cycle Cost (LCC)

“Loose Peanuts”

AirSeal

AirWrap

Product Carton

$ .37

Packing labor

$ .21

$ .13

Part (b)

AirSeal should dominate “peanuts” ($3.17 vs. $3.31), but the Purchasing Agent looks only at packaging

materials cost and chooses “peanuts” ($ .45 vs. $ .65).

Question 7

(a) Calculate the LCC per carton for College-Craft Glassware for AirSeal, AirWrap, and Cardboard.

(b) Based on part (a), what is the market potential for AirSeal and AirWrap for this customer?

Part (a)

Life Cycle Cost (LCC)

Cardboard

AirSeal

AirWrap

Shipping Carton

$ .45

Packing Labor

$ .12

$ .03

Freight Cost

$ 2.30

$ 2.25

Packaging Material

$ .55

Total Shipping

$ 3.42

$ 4.38

$ 3.49

Freight Cost

$ 2.05

$ 2.00

Packaging Material

$ .45

Total Shipping

$ 3.08

$ 2.86

$ 3.31

$ 2.89

Total Capacity

961 million sq ft.

Less Air Cap Sales

721 million sq ft.

= Available for Uncoated Volume

240 million sq ft. (per Question 2)

Maximum Uncoated Sales

240 million x $29 / 1000 = $6.96 million

2-5

Part (b)

Although the “Value Proposition” for AirSeal is $ .89 per shipment ($3.49 vs. $4.38), the Purchasing Agent

chooses cardboard because of the packaging material cost ($ .55 vs. $.69).

Question 8

(a) What annual sales level for AirWrap can be supported using the excess capacity on the AirSeal

equipment as of 1985? Assume average price of $29 to distributors.

(b) So what?

Maximum sales are only about 6.5% of the potential U.S. bubble wrap market in Cells II, III, and IV (7/108),

Question 9

(a) Estimate the variable cost per 1,000 sq. ft., on average, to manufacture and ship AirWrap using the

AirSeal Equipment. (Assume the average bubble thickness is 3/16 inch.)

Raw Material (weighted average of 2.90 and 9.11)

$3.22

Variable Manufacturing OH (given)

$1.94

Freight (from the case for 3/16” bubbles)

$2.64

Sales Commission (2%)

$ .58

Total

$8.38

(b) Estimate the full cost per 1000 sq. ft., on average, to manufacture and ship AirWrap using the AirSeal

Equipment.

Variable Cost (as above)

$ 8.38

Factory Labor Cost($10.3 million  961 million sq. ft.)

Fixed Manufacturing OH ($2.6 million  961 million sq. ft.)

$21.81

(c) Comment on the estimated contribution margin and gross margin of AirWrap when produced on

AirSeal machinery.

2-6

Question 10

(a) Estimate the full cost per 1000 sq. ft. to manufacture and ship AirWrap using its own equipment.

Raw Material

$ 3.22 (assuming 3/16” is the “average” product)

Var Manufacturing OH

$ 1.94

$ 6.45 ($6.2 million  961 million)

$ 1.70 ($1.63 million*  961 million)

Freight

$ 2.64

Sales Commission

$16.53

*Depr. = $1.3  2 = $.65; Other = $1.3 x 75% = .98; total = $.65 + $.98 = $1.63 million

(b) Comment

Question 11

(a) Estimate the ROI for AirWrap if it could operate at 90% of capacity in its own manufacturing

facilities. Assume Selling and Marketing at 7% of Sales, R&D at zero, and Administrative cost at 3%

of Sales. Assume the $29 average selling price.

Income Statement (Millions$)

Sales

$25.1

(961,000 x .9 = 865,000 x $29.)

Raw Material

$ 2.8

(865,000 x $3.22)

$ 6.2

Given

$ 1.7

($1.94 x 865,000)

$ 1.6

(from Question 10)

Freight

$ 2.3

($2.64 x 865,000)

$ 2.5

(10%)

$ 0.8

(3% of $25.1)

Investment

$ 3.0

(4 inventory turns: $12.3 ÷ 4)

$13.0

ROI = $7.2 / $19.1 = 37.7%, with excess capacity of 10% included in the costs.

(b) Comment

2-7

This is better than AirSeal in 1985 (27%). This result is very good, for a mostly undifferentiated product.

With substantially higher volume over time, AirWrap might actually produce more total profit dollars than

AirSeal, at a good ROI.

TEACHING STRATEGY

The case will easily support two class periods of ninety minutes each. In fact, I don’t think it is fair to the students to

ask them to prepare the case in one three-hour block (normal preparation time for one ninety minute class). When

using the case over two class periods, I assign Questions 1 through 5 for day one, and Questions 6 through 11 for