ACG 5075 – Group Case – OrangeYou have recently joined Orange Inc, a listed company in Clearwater, Florida that produces luxury yachts.Orange has organized production and sales of the yachts in two segments the ‘lower’ segment, where the average yacht is sold for $1 million, and the ‘upper’ segment, where a typical yacht is sold for $12 million. Orange’s pricing policy differs for the two segments. Yachts in the ‘lower’ segment are sold at a modest profit margin, while margins in the ‘upper’ segments are much higher. The rationale for this pricing strategy is to have higher levels of production so that the fixed cos

ACG 5075 – Group Case – Orange

You have recently joined Orange Inc, a listed company in Clearwater, Florida that produces luxury yachts.

Orange has organized production and sales of the yachts in two segments: the ‘lower’ segment, where the average yacht is sold for $1 million, and the ‘upper’ segment, where a typical yacht is sold for $12 million. Orange’s pricing policy differs for the two segments. Yachts in the ‘lower’ segment are sold at a modest profit margin, while margins in the ‘upper’ segments are much higher. The rationale for this pricing strategy is to have higher levels of production so that the fixed costs are spread over a larger base, thus reducing the cost. In addition, the target customers for the ‘upper’ segment are deemed less price sensitive.

Orange’s customers are typically wealthy individuals (end-users) or agents, which assist their customers in the purchase and interior design of the yachts. In the last fiscal year (2013), half the sales in the ‘upper’ segment were to end-users, while the other 50% of the customers were agents. For the ‘lower’ segment, the clients were mostly agents.

Main deck of a demo yacht

As a result of the housing and credit crisis, sales growth and profitability have slowed down. This is largely attributed to a sales drop in the most profitable ‘upper’ segment (sales in the ‘lower’ segment remained stable). Mr. Orange, the initial founder and currently president of the Board of Directors, believes that a crisis is simply an opportunity in disguise and has demanded top management to come up with credible plans to grab ‘this opportunity’ to grow profits. Previous occasions where Mr. Orange turned sour have always resulted in the replacement of senior management.

As a new hire to the controller department, you are invited by the CFO to discuss firm performance, and participate in discussions to explore possible alternatives to improve performance.

Pricing strategy

Required:

a. Comment on Orange’s pricing strategy (higher volumes as a result of lower profit margins in the ‘lower’ segment); what are the pros and cons? (Use ‘common sense’.)

Benchmarking

You are asked to compare Orange’s firm-level performance with peer companies that operate in the same industry for 2012 – 2013. Exhibit 1 holds financial information for Orange Inc. Details on how to obtain the data are provided in the PowerPoint document (‘case.pptx’) (Sakai, resources/group case/case.pptx).

Required:

b1. Compare the performance of Orange Inc. with its industry peers using WRDS using ‘DuPont’ ratio analysis. Consider all listed firms that operate in the same industry (SIC code 3730 ‘Ship and boat building and repairing’).

b2. Repeat the analyses for a few firms (at least one, but no more than three, depending on data availability) with activities that are very similar to those of Orange Inc. (i.e., also producing yachts).

End customers

For internal purposes, Orange Inc. uses quarterly income statements, where the revenues and expenses are not further broken down by customer type (just as in Exhibit 1). Orange is active in two market segments, and within each segment they have the end-users and agents as their clients. In general, agents get a discount of 10% of the sales price, while end-users do not get such discounts.

You have contacted the IT department, which has constructed an Excelsheet for you with the underlying data for the fourth quarter of 2013 (Sakai, resources/group case/case.xlsx). This quarter is representative for the full year.

For each completed project, you have the following information:

– type of yacht (‘lower’ or ‘upper’ segment)

– customer type (end-user, or agent)

– sales price (excluding discount)

– discount offered (10% for agents)

– the manufacturing cost of the yacht

Required:

c. Make a 2×2 breakdown of the data. Provide sales and gross margin for each segment (‘lower’ and ‘upper’), as well as by customer type (end-user, agent). Where is Orange making the profits?

Job costing

Orange has always used a simple job costing system. Direct materials and direct labor are added to each job’s account. Manufacturing overhead is allocated at a rate of 100% of the direct material dollars. Since each of the yachts is unique, the manufacturing costs are different for every product. Nonetheless, you have obtained a ‘standard cost’ for each of the two product segments (‘lower’ and ‘upper’), see Exhibit 2.

You notice that overhead costs are large. You find estimates of the breakdown of manufacturing overhead and their cost drivers in Exhibit 3.

Finally, you have found information on the collaboration with agents. The sales managers are heavily involved with the agents, prior to each sale, as well as throughout the production process. On the other hand, the corporate web site mainly results in sales to the direct end-user customers, and requires little effort of the sales managers. Of the $10 million selling, general and administrative (SG&A), $4 million is related to dealing with agents, while $500,000 are fixed costs for the website, which are most appropriate to allocate to end-user customers. There is no information to allocate the remaining $5.5 million in a meaningful way.

Required:

d. Explore the sensitivity of the product costs to alternative overhead allocations that take the above information into account.

e. Summarize and conclude all your findings from a-d.

Exhibit 1 – Financial data Orange Inc.

in $ millon 2011 2012 2013

Sales $230 $200 $180

Cost of goods sold $160 $155

Gross margin $40 $25

SG&A $10 $10

Interest expense $15 $15

Profit before tax $15 $0

Income tax (40%) $6 $0

Net income $9 $0

End of year balance sheet items

Working capital $40 $40

Long term assets $300 $300

Total assets $400 $400

Interest bearing debt $200 $200

Total equity $150 $150

Exhibit 2 – Standard costs of typical ‘lower’ and ‘upper’ segment yachts

‘lower’ segment ‘upper’ segment

Direct materials $ 385,000 $ 4,000,000

Direct labor 80,000 500,000

Overhead allocated 385,000 4,000,000

Standard cost $ 850,000 $ 8,500,000

Profit margin 150,000 3,500,000

Sales price $ 1,000,000 $ 12,000,000

Use of cost drivers

Direct labor hours 1,600 10,000

Machine hours 3,200 15,000

Exhibit 3 – Manufacturing overhead breakdown

This exhibit shows a breakdown of the overhead for the fourth quarter of 2013, where manufacturing overhead was $17.5 million. For each item, the main cost driver is included.

Item driver

Engineering/design direct material dollars $ 3,000,000

Construction machine hours 7,500,000

Systems installation direct labor hours 3,500,000

Supervisors/project managers direct labor hours 2,500,000

Miscellaneous machine hours 1,000,000

Total manufacturing overhead $ 17,500,000