Lipton Case Review – Mba Managerial Accounting Flashcard
Executive Summary Detailed analysis of Lipton’s current Economic Profit model has prompted immediate changes to how profit is recorded on the Product Line level. Proposed changes to the current Economic Profit include: I. Leave the Working Capital Cost and CRV Depreciation Adjustment in the profit analysis II. Eliminate the Fixed-Asset Charge and OI&D III. Only apply New Product Development charges to new products Goals of these proposed changes: Ensure product line managers are focused on improving the value of their product, not just on profit/loss numbers * Allow upper management to analyze product line performance on a level playing field * Provide divisional management with the unbiased authority to allocate fixed asset costs * Enable upper management to make decisions regarding a product line’s value to their division and the overall value of Lipton, and report required performance metrics to Unilever.
Background Unilever’s Evaluation Criteria include the following metrics: * Capital Turnover- Net Sales / Ave Gross Capital Expenditure * Return on Sales- Profit Before Tax / Net Sales * Return on Capital- After Tax Return on Ave Gross Capital Employed Their Financial and Operating Objectives include: * Sales growth by 10. 5% per year * After tax profit margin to improve by 6% * Achieve 15% after tax return on ave invested capital (ATRIC) * Maintain AA Bond rating
The financial department has recently changed Product Line Profit and Loss (P/L) from “Trading Profit” to “Economic Profit. ” The objective of this change was to reflect a more accurate contribution of each product line to the overall corporation. The chart below shows the changes implemented and the subsequent affects to the resulting Economic Profit: Changes to Trading Profit| Resulting Affects to Proposed Economic Profit| Working Capital Charge| Reduce profit to account for interest cost of apital| CRV Depreciation Adjustment| Reduce profit to account for difference between CRV and historic depreciation| Fixed-Asset Charge| Reduce profit to account for fixed cost (as % of total fixed costs)| OI&D and other| Increase/Decrease profit depending on the benefits or costs to the brand| New Product Development Charge| Increase (unless the particular product line is a new product)| It is our understanding that the financial department suggested these changes because the original Trading Profit did not evaluate individual product line performance at the same economic level as Unilever and corporate management.
While the resulting Economic Profit does address some problems with the original Trading Profit, we believe that some of the changes are unnecessary. Additionally, the new Economic Profit evaluation could send mixed messages to product line managers since profit will be understated. Therefore, we propose the following changes to the Economic Profit structure. Proposed Adjustments to the Economic Profit Working Capital Charge The corporate financial department was correct to include this negative adjustment to trading profit. The working capital charge makes product line managers responsible for their liquid assets.
By assigning a cost of capital to the product line’s total working capital, product managers are penalized for keeping too much cash around. Instead, the managers are motivated to improve the economic profit by applying otherwise dormant working capital to product line efficiency. This cash can be used to update fixed assets (new technology), positively affect customer service, enhance product marketability, or even reduce debt. Reducing short and long term liabilities actually helps the overall company align their interests with Unilever’s desire to maintain a AA Bond rating.
Meeting these liabilities lowers the overall risk of default in the eyes of debt holders. As a result, the rating agencies will score Lipton higher than they would if Lipton were not meeting their obligations. Therefore, by assigning a cost of capital that reduces economic profit, product managers are incentivized to re-invest their working capital to better the company as a whole. CRV Depreciation Adjustment This adjustment accounts for the difference between the “current replacement value” and the historical depreciation value of assets. The purpose of the CRV adjustment is to assign replacement value to depreciating assets.
As a result, the opportunity cost of these assets is deducted from a particular product line’s profit. The challenge associated with this adjustment will be directly related to properly allocating a % of fixed assets to a particular product line. We will address the issue concerning the allocation of fixed assets below (Fixed-Asset Charge). Consequently, this is the same method used by the corporate financial department. Therefore, by including the CRV depreciation, corporate managers will be pleased that product line performance measures are factoring in this opportunity cost.
Furthermore, product line managers must be weary of fixed asset costs because of the CRV depreciation adjustment’s negative effect on economic profit. Fixed-Asset Charge Fixed Asset charges are difficult to estimate and allocate to a particular product line. Under the old Economic Profit system, many product lines could post losses due to large fixed cost allocations. When losses are associated with a product lines, managers naturally panic. Therefore, we believe that all fixed assets should be evaluated on an Operating Division Level. The three primary operating divisions at Lipton include: Beverage, Food and General Management.
Food Food Beverage Beverage GM GM Divisional Approach to Fixed Assets | Beverage Division| Food Division| General Management| DEFINE| Fixed Assets include all of the facilities, machinery and other long term fixed assets used to produce Lipton beverage products. | Fixed Assets include all of the facilities, machinery and other long term fixed assets used to produce Lipton food products. | Fixed Assets include all of the facilities and other long term assets used by general management. | ASSIGN| Determine which beverage product lines use a particular fixed asset. | Determine which food product lines use a particular fixed asset. Assign fixed assets to appropriate general management offices worldwide. | EVALUATE| Calculate a percentage of each FA cost to a particular product line. Evaluate at an upper management level. | Same upper management evaluation as the beverage division, but for the food product lines. | Determine % and value of fixed asset costs to each reporting management entity. | IMPROVE| * Share results with product line managers * Are there any red flags associated with a product line? * Use information to minimize costs by properly utilizing FA across both divisions. | * Are there any red flags? Review FA cost on a division and company level| Big Picture Goal: Assign Total Fixed Costs to each Division Added Benefit: Discover product line contribution to Fixed Asset Costs and cost minimization. Allocations can be used to assign CRV adjustment value to each product line. Since there are multiple fixed assets associated with each division, the divisional managers should first define the Total Fixed Costs per division. Then, the overall divisional fixed costs can be assigned to each product line based on the assets it utilizes (or as a % of the fixed asset that it shares with other product lines).
Upon evaluating each product line’s contribution to fixed asset costs, the Operating Division’s management team can then deduct the Total Fixed Costs from overall economic profitability. Furthermore, the management team can work with product line managers to get an idea of which product lines utilize more/less fixed assets. This puts the responsibility of fixed assets on the management team, and allows the product line manager to focus on other tasks than improving profit margin. Lastly, the allocation of fixed asset costs to a particular product line allows for product managers to properly report the CRV adjustment value.
OI&D and Other The “other income and deductions” items applicable to product lines should be removed from the economic profit analysis. The benefits and costs to the brand are vague and could vary drastically from month to month. Also, these benefits and costs are typically low considering normal variable costs and overall profit. Therefore, instead of product managers focusing on maximizing their “other income” to increase the bottom line, they should be focusing on maximizing productivity and minimizing operating costs.
Our team recommends that these OI&D numbers are collected on a monthly basis and reported to Divisional Management. The Divisional Management’s financial team can compile this information and provide feedback to any product line that could have some problematic numbers. Furthermore, upper management could reward the product line that posts the highest OI&D as a percentage of economic profit (perhaps an extra day of vacation per quarter). This would give each product line some incentive to increase the benefit to the brand, without placing too much emphasis on these activities.
After all, Unilever evaluates Lipton’s performance based on improving sales and return on investments. While receiving tax benefits, payment discounts and operations income are beneficial to a particular period’s income, product line managers should be held responsible for the “big picture” state of the product’s profitability. New Product Development Charge It is very clear to our team that this charge should only apply to new products. Therefore, the New Product Development Charge should have never been included on the original Trading Profit.
The sole exception would be for actual new products that were being developed. The associated costs would be applied to that product line’s P/L evaluation. This way, the costs of the development are directly reported to the appropriate product responsible for the costs. As a result, pre-existing product line profits will not be lowered by new product development. Furthermore, the product manager can better estimate how long a product line will take to increase profit margins based on their initial product development investment. Revised Economic Profit
XYZ Product LineEconomic Profit and Loss(in thousands of dollars)Sales $30,274Historical cost trading profit $ 4,526Working capital charge (2,416)CRV depreciation adjustment (547)Fixed-asset charge (2,821)OI&D and other 148New product development charge 244Economic Profit $ (866)| XYZ Product LineNEW Economic Profit and Loss(in thousands of dollars)Sales $30,274Historical cost trading profit $ 4,770*Working capital charge (2,416)CRV depreciation adjustment (547)Economic Profit $ 1807| *Trading Profit adjusted positively to reflect the elimination of the New product development charge for existing product lines.
It doesn’t make sense to deduct something and then add it back later. Using Product Line XYZ as an example, it is clear that the revised Economic Profit model paints a very different picture. The previous model resulted in an $866,000 loss. By removing the Fixed-asset charge, OI&D and New product development charge, XYZ looks to be in much better shape ($1,807,000 profit). This change can have a big impact on product line managers and resonate at the corporate level. If the manager of XYZ were reporting losses based on the old economic profit model, his/her primary goal would be to increase profits. This could lead to some bad business decisions as a result of efforts to cut out costs.
For example, the manager could lay off workers, use cheaper packaging, downsize their facilities, etc. , all because of the negative profit being reported. As seen through the new Economic Profit model, Product XYZ looks to be doing just fine now that fixed assets (which are sunk costs anyway) have been removed from the equation. By eliminating the scrutiny over improving profit, the product line manager can now focus on improving other important factors crucial to the success of the product line. These factors include: Raw material and scrap management, Inventory management, Machine improvement and efficiency, Product quality, Customer management and development (delivery, customer service, sales, and marketing) and overall Innovation.
Non-Profit Performance Measures for Product Line Managers Raw Material and Scrap| | Number of Vendors| Identify if there is enough competition between suppliers| Cost of RM| Analysis to minimize cost for product inputs| Lead time for RM| Work with existing (and new) suppliers to minimize delivery lead time| Scrap costs| Determine acceptable level of scrap and monitor levels| Quality control| Raw material QC, receiving inspections| Inventory| | Ave Value| Calculate and monitor value of finished bev/food inventory| Inventory Turnover| Calculate ave time it takes to move inventory| Cust. Inventory Management| Communicate with customer to maximize efficiency| Machinery| |
Machine Downtime| Identify which machines are potentially worth replacing| Bottleneck Analysis| Identify current and potential bottlenecks, minimize effects| Maintenance Reports| Confirm all machines are operational, safe and optimized| Setup Time| Determine which machines are easier to setup and run| Product Quality| | Customer Acceptance| Set standards, monitor complaint and return levels| Quality Control| Set standard: 100% good product to be shipped| Quality Costs| Analyze the costs associated with QC meeting the set standard| Customer Management| | Delivery| Collect and review metrics to analyze production and delivery performance| Customer Service| Focus on improving communication through acquiring feedback| Sales| What can be done to improve market share? Analyze sales team’s performance. | Marketing| Maintain a return on marketing activities. | Innovation| |
Process Improvement| Study how to improve all steps of the manufacturing process| Resource Sharing| Meet with other product managers to potentially minimize costs| Team Building| Increase morale and efficiency through effective leadership| All of these factors go into the success, or failure, of a particular product line. Therefore, product line managers should not be wasting their efforts by focusing solely on improving economic profit. Upper Management Under the new economic profit analysis, upper management can now rest assured that their product line managers are focused on improving all aspects of each product. Furthermore, each divisional management team can focus on assigning fixed costs to a particular product line. This removes bias from the allocation of fixed costs because the divisional management team will be reporting to corporate management.
Under the previous economic profit analysis, product managers would have been encouraged to lower the allocation of fixed assets (or perhaps invest less capital on expanding production capabilities), in order to improve profit. Additionally, upper management can now evaluate the performance of all product lines on a level playing field. If particular products are struggling, it will be apparent that their difficulties are not being caused by over allocation of fixed costs. Upper management can determine, at the appropriate level, whether a product line is economically profitable to the overall company value. After all, upper management must meet Unilever’s performance standards.