Reichard Maschinen, GmbH Will The Price Steel Rings Fall One fourth

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Reichard Maschinen, GmbH

Teaching Commentary

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

The case is a very good classroom vehicle for illustrating several different layers of sophistication in 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.

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 ninety-minute class period.

CASE ANALYSIS

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

ANSWERS TO ASSIGNMENT QUESTIONS

Question 1

This question asks for the differential cost to produce 100 plastic rings. The relevant cost calculations are

Question 2

This question asks for the incremental cost to produce the next 34,500 steel rings (see Table 1). The firm

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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.

Question 3

This question asks for the differential cost of the

25,450 steel rings that already are in inventory at the end

Question 4

This question asks which ring is more profitable,

steel or plastic. Another layer of complexity is added

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 less than the demand that

currently exists for the steel rings. If the firm switches to

plastic rings but 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

Plastic rings vs. the 25,450 steel rings in stock.

When plastic rings are compared to the 25,450 steel rings

now in inventory, the steel rings are far more profitable

because their marginal cost is zero. Any revenue gained

that 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

week x 52 weeks), steel rings contribute $58.883.

Correspondingly, with a yearly volume of 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

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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.

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 ring

production will require only about 10% of the direct labor

Question 5

1. Stay with steel only.

Business as usual. The firm could tell its customers

right away that an “experimental” plastic ring is also

2. Move to plastic only—Get ready to make plastic

rings as soon as possible.

A. Right away—Stop producing steel rings now.

Throw away the existing inventory of raw

material. Sell from the existing inventory of

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.)

C. Later—Introduce plastic only after the full

Question 6

As discussed earlier, the financial analysis in

Table 2 yields the following conclusions:

1. For the next of 25,450 rings, steel rings are much

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

2. Will the price of steel rings fall to one-fourth of the

price of plastic rings, or will plastic ring prices rise?

3. What effects will the decision in respect to plastic

rings have on the sale of machines?

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5. Should the firm exert its leadership in markets other

than Belgium by being the first to introduce plastic

rings? How much “strategic” value is there in being

the “first mover” in other markets?

6. How long is it prudent to continue to try to sell a

likely to switch from steel to plastic.

Uncertainties regarding steel and plastic ring

prices. In the financial analysis shown in Table 2, we

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.

1. Given that plastic has four times the wearing

properties as steel rings, one might argue that the

2. All of these factors suggest that, in the long run, the

market price for plastic rings will probably be the

3. Once customers are convinced that the plastic ring

does in fact last four times as long, will they pay

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

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 stands to lose far more

than what it saves on rings. With twenty-four rings per

year, the steel ring cost is $6 per month on a $6,000

machine. In other words, the potential for damage to

machines by using plastic rings may not be worth the

rings to customers but emphasize the “experimental”

nature of plastic. This might allow the firm potentially to

sell all their existing steel rings and the ones they can

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

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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 not nearly as attractive.

The students will see that, financially, Reichard

has the incentive to forestall the market’s move toward

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.

1. Sell the 25,450 steel rings that are currently in stock.

If the firm can sell them for at least $77 per hundred

would be $77, which equals that from plastic rings.

3. Do not buy any more steel.

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.

Assuming Reichard converts its raw steel into

rings, how can they manage the market transition from

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 show up directly in the

accounting reports. The value of “flexibility” is real and

perhaps deserves as much attention, in many situations as

the value of “efficiency.”

TEACHING STRATEGY

for various decision options. The instructor’s job is to

keep the discussion moving and make sure all the twists

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Table 1

Relevant Costs

(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

Plastic Rings

Full Cost Variable Cost

Raw Materials $4.20 $4.20

Notes:

1. Assume that the “make work” projects have zero real value to the company.

Table 2

Comparison of Incremental Profitability

Steel Rings

25,450 Next Future Rings

Rings 34,500

in stock Rings Contribution Full Cost

Plastic Rings

“Contribution” “Full Cost”

Analysis Profits

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Annual Contribution of Plastic and Steel Rings

In the Future Now

Item Plastic Steel

Sales Price ~ $80.00 $325.00

Variable Costs:

Notes:

1. The firm currently sells 35,880 rings per year (690 x 52).

Table 4

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

How would you think about this problem?

We sell about 36,000 rings/year

IS THIS “GOOD THINKING?”