Improving the link between sales and production in the
Nijburg Industrie Groep
University of Groningen
Faculty of Economics and Business Technology Management
Master Thesis
Author: Jurjen Draaijer First supervisor: J. Slomp
Improving the link between sales and production in the
Nijburg Industrie Groep
Jurjen Draaijer
University of Groningen
Faculty of Economics and Business
Abstract
Management Summary
The goal of this report is to design a solution on how a sales and a production organization should behave with reference to each other in an investment Group. Thus, to increase the link between the organizations.
The problems of the Nijburg Industrie Groep (NIG) will be used as an example of the problems that can occur when no, or almost no, regulations are in place between a sales and a production organization. The organizations considered in this research are the organizations in the sales cluster, and the production organization Nijburg Products (NP). The production organization of the NIG, NP, has problems covering the production costs of special products. Because the sales organization of the NIG provides discounts to customers, the production costs caused by the special product cannot be covered anymore because NP gets a fixed share of the sales price as “cost price”. This leads to stability problems of NP. Furthermore, there is not determined between the sales organization and NP when to accept orders and when to refuse orders. This also leads to an unstable situation because the price of the order could be too low to cover the production costs. Because of the increased number of competitors and the dropping demand to build offices the sales prices of the products of NP is decreasing. This affects the sales price, and therefore the cost price, because the sales price and cost price are connected.
From this point of view the research goal is being set as
The conceptual model can be depicted as
Structure can be described as: ”who has which responsibility”. The structure variable influences the processes of NP because processes are based on a structure. Furthermore, the method of calculating or determining the cost price influences the process. In case of calculated cost prices this leads to decision making based on the cost price, which influences the processes of NP. How can the stability of Nijburg Products be improved?
Cost price Processes
Furthermore, the process of NP can be described as: “who applies which task”. The process variable influences the stability variable of NP, because the number of errors made during the process, the stability is influenced. Three sub questions are determined in order to increase the stability of NP. These will be discussed next.
1a. What are the characteristics of the structure of NP and how can it be improved? 1b. How does the current structure influence the process?
In order to answer sub question 1a and 1b the work preparation and engineering department will be considered because of the relevant responsibilities of these departments. The responsibilities for the work preparation department relevant for this research are:
Make offers for special products;
Process sales orders of special and standard products;
Make a production planning;
The responsibilities for the engineering department are:
Make a drawings for special products offers
Maintaining the ERP system
In order to improve the structure of NP, there should be known who has which responsibility and how has to be dealt with the responsibility. To sell products for less than the production costs some conditions are designed:
Customers willing to pay 70% to 100% of the sales price should be always accepted;
In case if the price drops to less than 70% percent of the sales price, at least the variable cost should be covered. Furthermore, the expected production is achieved;
There should be an overcapacity at NP, if 70% or less of the catalogue price is covered; Furthermore, NP and the sales organizations should accept these conditions in order to prevent sub optimization. In the case of NP the AMSP should be the one that should accept this responsibility because the AMSP has the best knowledge about products
2a. What is the current method to determine the cost prices of NP?
2b. How does the current method of determining the cost prices influence the process? At the current situation the share NP receives for manufacturing a product depends on the sales price. For special products this is 55% of the sales price, for standard products this is 40% of the sales price. Due to heavy competition of other organizations in the same market, the economic situation and an increasing number of flex workers, the sales price drops, resulting in a lower amount of money for NP. Therefore, this situation affects the stability of NP. In order to optimize the situation, the cost price should be calculated instead of be a share of the sales price. The costing method that fits NP best is job order costing. With help of the cost price method job order costing the production costs of products can be calculated. With the production costs known, the process variable will be influenced. Not every order should be accepted anymore. For example, if there isn‟t an overcapacity and the customer would like to have a discount, the order can be rejected, because other orders will increase the profitability more. In the next sub question the result of using production costs will be discussed.
3a. What are the characteristics of the processes of NP and how can it be improved? 3b. How do the current processes of NP influence the stability?
order to check the used sales price and intercompany price. The third problem is a software problem: if the delivery date of the special order changes, the numbers are changing back to their original state. This leads to an unstable situation for NP, because not all tasks perform optimal.
The first problem was that the intercompany price is being inserted as the sales price in the ERP system. A solution for this problem is to organize a seminar to improve the knowledge of the sales agents of the ERP system. Furthermore, a sort of poke yoke system should be designed that makes it impossible to make errors by adding the sales price to the ERP system. The second problem was that the AMSP is not always being informed about special orders. This can be easily solved by providing the work preparation department access to the offer prices that are provided to the customers. If this is the case, the work preparation department can check the sales prices instead of the AMSP, resulting in fewer errors. The last problem was related to the second problem, and was that a technical problem of the ERP system leads to resetting the data to the initial values in case of a change of, for example, the delivery date. This should be solved by the IT department, but when this is not the case, the work preparation department should check if the sales price is still right if the delivery date changes.
Furthermore, the process of accepting and refusing orders with a low sales price is designed for the AMSP. There are four possibilities if an order will be accepted or refused:
The first possibility is that the production is higher compared with the expected production, and there is an overcapacity. If this is the case the order will be accepted.
Second, the production is lower compared with the expected production and there is an overcapacity. The order can be accepted to keep the machines running and the employees paid. However, NP will lose money if this is structurally the case. Now, the machine costs and the labor costs will be covered somehow. By refusing this order this is not the case and the loss will be maximized.
Index
1. Introduction ... 8
1.1 Goal of this report ... 8
1.2 Problem context... 8 1.3 Problem statement ... 11 1.4 Conceptual Model ... 12 1.5 Research questions ... 13 1.6 Focus area ... 14 1.7 Methodology ... 14 2 Diagnosis ... 16 2.1 Structure of NP ... 16
2.2 Determining the cost price ... 17
2.3 Processes of NP ... 20
3. Design ... 29
3.1 Structure of NP ... 29
3.2 Cost price methods ... 34
3.2.5 Designing a job-order costing system ... 40
3.2.6 Create understanding between the organizations ... 44
3.3 The processes of NP ... 51
4. Implementation ... 58
4.1 Structure of NP ... 58
4.2 Cost price methods ... 58
4.3 Processes of NP ... 60
5 Conclusion ... 61
5.1 Findings at the NIG ... 61
5.2 General findings ... 65
6 Further research ... 66
7 References ... 67
Appendix I – Details of the OKNI product family ... 69
Appendix II – Labor measuring sheet ... 71
1. Introduction
This chapter will introduce the problem, the Nijburg Industrie Groep and provides an overview of the activities performed by the different organizations in the group that is relevant to know for the research that will be conducted.
1.1 Goal of this report
A corporate group is a group of companies that performs business in different markets under common administrative or financial control whose members are linked by relations of interpersonal trust on the bases of similar personal ethnic or commercial background a business group (Leff, 1978). The type of organizations in a business group can be diverse. Examples are production organizations, sales organizations, (product) sustaining organizations, etc. If no agreements are made between organizations in a corporate or business group, this will lead to sub optimization. For, example, all organizations would like to maximize their profit, even if this leads to a lower profit of the other organizations in the group. Therefore, it leads to problems. With no agreements between the organizations in the business group made, it is not clear how the organizations should behave with respect to each other. Thus, how should a sales organization behave with respect to a production organization, and a production organization with respect to a sales organization? This report focuses on the current situation at the Nijburg Industrie Groep (NIG). The situation of the NIG will be used to find a solution on how the organizations, and especially the production and sales organization, in a group should behave with reference to each other.
Summarizing; the goal of this report is to design a solution on how a sales and a production organization should behave with reference to each other, thus, to increase the link between the organizations. The problems of the NIG between the sales and production organization will be used as the starting point that illustrates this research.
1.2 Problem context
Nijburg Industrie Groep
Sales cluster Installation cluster
Solid Air Velu Fair
Production cluster
Nijburg Products Roy Air
Nijburg Luchttechniek
Figure 1-1: Organisation layout Nijburg Industrie Groep
Sales cluster
The sales cluster consists of the following organizations:
Solid Air (SAL)
SAL is located at Amsterdam and serves the worldwide market with distributors in Belgium, France, Italy, Australia, and the USA. SAL distributes products and gives advice to installation organizations.
Velu Ventilatie Techniek (Velu)
Velu is located at Sappemeer and is a wholesaler in air technical components in the residence, ship and utility market.
Fair Luchtbehandeling (Fair)
Fair designs air controlling systems for, for example, hotels, shopping malls, swimming pools etc. Fair is located in ‟s-Hertogenbosch.
Installation Cluster
The installation cluster consists of the following organizations:
Nijburg Luchttechniek (NLT)
NLT is located in Groningen. NLT is specialized in project preparation, engineering and supervising, and installation of complete air transport systems for the utility building and industry.
Production cluster
The production cluster consists of the following organizations:
Roy Air (RO)
products as NP (see next bullet point), but with a slightly different architecture, and therefore different production processes.
Nijburg Products (NP)
NP is located in Sappemeer. The turnover is approximately 24 million euro (budget Nijburg Products BV, 2011), supported by 90 FTE with 59 of the total amount working as production employee. The factory is divided in the next departments: logistics, purchasing, production, development, planning and technical service.
Both the sales cluster and the installation cluster buy their products from NP. However, the sales cluster also buys from other organizations because the sales organizations act as a wholesaler because not everything can be manufactured at NP. Furthermore, the installation organizations buy products from the sales organizations. However, the installation cluster of the NIG in some cases buys their products, direct, from the production cluster.
The ERP system of the NIG is the most important information technology system being used in the organization. All organizations in the NIG work with the same IT system. In this case the ERP system is Microsoft Axapta 3.0. For example, the sales organizations use the ERP system to add sales orders and create invoices. Furthermore, NP creates production orders and are planning the production process with help of the system.
The sales organizations in the NIG behave like a wholesaler, every product that a customer would like to buy can be made in order to keep the customer satisfied. Treacy & Wiersema (1995) describe this phenomenon as “customer intimacy”, “Customer-intimate companies don't
deliver what the market wants but what a specific customer wants”.
The result of choosing a customer intimacy strategy is that the ERP system should be designed in such a way that all products can be handled, even products that are not sold before. Therefore, the NIG distinguishes two types of products, standard articles and special products.
Standard products
Standard products are products that are present in the product catalogs distributed to customers of the sales organizations. These standard products have some predetermined properties like dimension or color. Also the sales price is predetermined, as being stated in the catalog. In case of adding a sales order to the ERP system the predetermined properties can be used to add the article to the system. This is done with help of a “product builder”, a sort of product generator. This “product builder” checks if the properties are compatible and selects the right sales price. The problem with a product builder is the fact that standard products only have a limited number of properties. Therefore, it is not possible to add “new” products, products that are sold for the first time, because the combination of properties is not possible in the system. If this is the case the solution is to make use of a special product in the ERP system.
Special products
1.3 Problem statement
In the current situation, the sales organizations determines if a product should be a standard, or a special product. This leads to the problem that a product will be ordered as a special product instead of a standard product, even when this is not the case. Rumors are saying that the sales organizations do this with a reason. The given reasons of selling a special product are that the sales organization can provide the special product for a low price to the customer because the price is determined by the sales organizations. This results in a lower sales price and, therefore, a lower compensation for NP, because the share NP receives of the total sales price, the “cost price”, is a fixed percentage of the sales price. Because the compensation for the production of the special products is low, it can become be a problem for NP to cover all the costs made to produce a special product. For NP, this leads to a loss on the special products and, therefore, to an unstable situation. Furthermore, compared with competitors, the sales prices the NIG uses for special products are rather low. Employees are indicating that the sales prices are in some cases three or four times lower compared with competitors on some product families. Therefore, it can be the case NP always loses money on special products. Because the exact cost price is not calculated, the cost price is share of the sales price, this is not known exactly.
Furthermore, because the cost price is not known, no regulations are in place to determine which orders will be accepted an which orders will be refused.. The organizational structure and the process of processing orders are not designed for making such decisions. Therefore, this leads also to an unstable situation, because all orders are accepted right now because the cost price is not been calculated, and no decision mechanism is used to regulate this. Even if the cost price is far below the costs made to manufacture the product, the order will be accepted.
Another problem is the increased numbers of active competitors in the market. The prices of the standard products are decreasing because of this. The effect for NP is that NP receives less money per product because NP gets, as mentioned before, a fixed share of the sales price. This leads to the problem that the production costs of some specific standard products are not covered which will lead to stability problems. Another aspect of the declining sales prices are the economic crisis and the increasing popularity of working home (flexible working). Both reasons will lead to declining sales prices because the demand is decreasing because fewer offices are build.
Derived from previous the problem definition can be formulated as
Next, the conceptual model will be discussed.
1.4 Conceptual Model
A conceptual model represents variables that can be dependent, or independent. The independent variables will influence dependent variables so that, possibly, an improved situation occurs. The identified variables and their dependency are depicted in Figure 1-2.
Figure 1-2: The conceptual model
Next, the variables, as depicted in Figure 1-2, and their mutual relations will be discussed.
Stability of NP
An organization can be described as stable if the performance indicators have, somehow, the same values each week, month, year etc. Performance indicators are, for example, profit, products sold or number of employees. If the performance indicators change, it should be known why these indicators change so actions can be undertaken (for example by management) to correct it. In this context stability increases the continuity of the organization which should be one of the goals of an organization.
Now, the situation of NP is unstable. It cannot be explained why the profit is sometimes higher or lower with the same amount of products sold. Of course, the profit depends on the product mix of the products sold; however, at this moment it cannot be explained why there is or isn‟t a profit because it is not clear for which products the production costs are covered and for which products it isn‟t.
Furthermore, because of the financial crisis, the increasing competition and the decreasing demand of products of NP, the prices are dropping. This affects the “cost price” of the products of NP because it is linked. Therefore, there can be concluded that the situation of NP is unstable.
The stability of NP is influenced by the processes of NP. This will be discussed next. How can the stability of Nijburg Products be improved?
Cost price Processes
Process
The process of NP can be described as: “who applies which task”. The processes of NP should be designed in order to increase the stability. The processes of NP now are designed to support the current situation at NP. The process is being influenced by the “cost price”
Cost price
Right now, NP does not know what the cost prices of their products are. There is an indication, but the precise cost prices have never been calculated. Therefore, the margin on products is not clear. It can be the case that the production costs are covered, but it can be also the case that the production costs are not covered. The cost prices influence the processes of NP because if the method how to determine the cost price changes, therefore, the processes of NP should adapt to the new information that becomes available by changing the way how cost prices are being calculated. Calculated cost prices will lead to decision making based on the cost price, which influences the processes of NP.
Structure
Structure can be described as: ”who has which responsibility”. An example of responsibility is accepting or refusing orders, and determining the cost price of special products. The structure influences the process, because, when the responsibilities become clear, the processes should be designed in such a way that it supports the structure. Furthermore, the a weak organizational structure can lead to overhead because of, for example, too much employees for a responsibility, or no employees for a responsibility which will lead to errors in the processes.
Summarizing; structure influences the processes of NP because the process is based on a structure. Furthermore, the method of calculating or determining the cost price influences the process. In case of calculated cost prices this leads to decision making based on the cost price, which influences the processes of NP. Furthermore, the process influences the stability of NP. Because the number of errors made during the process, the stability is influenced.
1.5 Research questions
The research goal formulated above as:How can the stability of Nijburg Products be improved?
The sub questions related to the research goal are stated next.
1a. What are the characteristics of the structure of NP and how can it be improved? 1b. How does the current structure influence the process?
2a. What is the current method to determine the cost prices of NP?
1.6 Focus area
In order to ensure meeting the objectives for this research project, the focus of the project is set to indicate boundaries within which the project continues. The objective of this project is to improve the stability at NP. To achieve this objective within the available time, the scope of this research will be limited to some degree.
Of NP, the departments engineering and the work preparation department will be considered because there the relevant processes are applied. Next to NP, also the sales organizations will be, somehow, considered in this research because the variable needs that the sales organizations will be considered too because of the process variable that will be considered.
The variables, as mentioned before, that will be discussed are “cost price”, “process” and “structure”. Both variables will be researched with aid of theory. This theory is the starting point of the solution.
Next, the methodology used to answer the questions will be discussed.
1.7 Methodology
Per research question the used methodology will be discussed.
1a. What are the characteristics of the structure of NP and how can it be improved?
This question will be answered by conducting a research at NP on the work preparation department and the engineering department because of the processes that are applied within these departments. This should lead to information regarding the current structure of NP.
1b. How is the structure related to the process?
The result of the research as conducted in question 1a will be used to illustrate the relation between the structure and the process variable.
2a. What is the current method to determine the cost prices of NP?
This question will be answered by conducting a research at the financial administration of NP. This should lead to information regarding the current way of how NP determines the cost prices.
2b. How does the current method of determining the cost prices influence the process?
The result of the research as conducted in question 2a will be used to illustrate the relation between the cost price and the process variable.
3a. What are the characteristics of the processes of NP and how can it be improved?
With the insights AAD provides, it becomes possible to suggest improvements in order to increase the processes of NP.
3b. How do the current processes of NP influences the stability?
2 Diagnosis
In the diagnosis chapter the current situation of NP will be analyzed so that becomes clear why the problem that is described in the introduction occurs. In this chapter the facts that are causing the problems as discussed in the problem statement paragraph will be stated. The facts of the problem statement are the starting point of the design chapter.
2.1 Structure of NP
In this paragraph, the first two sub questions will be discussed. The sub questions are determined as:
1a. How is the current structure of NP designed and how can it be improved?? 1b. How is the structure related to the process?
This paragraph will discuss the current situation of the work preparation and the engineering department. Furthermore, there will be discussed how the structure is related to the processes variable.
NP is divided into a couple of departments. Examples of departments of NP are the four production halls, the engineering department, the work preparation department, the expedition department, the purchase department etc. Relevant for this research are only the work preparation department and the engineering department because of the responsibilities with reference to offer and order processing.
The work preparation department processes special and the standard sales orders. The responsibility for the work preparation department is to make an efficient schedule for the production halls, thus transform sales orders to production orders. Furthermore, the work preparation department should take care of the delivery date, and in case of a change, inform the sales organizations and change the production planning. The amount of stock in the storage is also a responsibility of the work preparation department. Sometimes products manufactured by NP need parts of other manufacturers. These parts that are bought from other manufacturers are kept on stock. NP has the responsibility to check if the “digital” stock equals the real stock, and to send a notification to the purchase department if the level of stock is below a certain point.
Member of the work preparation department is the Account Manager Special Products. This Account Manager Special Products (AMSP) receives offer requests for special products from the sales organizations. The AMSP has the task to inform the sales organizations and decide about the feasibility of the offer request on a financial and technical scope.
In the current situation, standard sales orders are always accepted. However, as mentioned in the problem statement, the sales prices of the standard articles are dropping because of an increasing competition, the economic crisis and the increasing interest in flex work. Therefore, it can be needed to decide to refuse an order instead of accepting the order because the sales organizations or NP are losing money on it. However, in some specific cases it can be a tactical decision to accept a sales order, even when the complete cost price is not covered. However, there is no regulation in place to regulate when an order should be accepted or refused. Therefore, procedures should be made to accept or refuse orders.
The responsibilities of the work preparation department and the engineering department, as discussed above, lead to processes to apply to these responsibilities. These processes of the departments will be discussed in paragraph 2.3.
Summarizing; the work preparation and engineering department will be considered in this report because of the most relevant responsibilities of these departments. The responsibilities for the work preparation department relevant for this research are:
Make offers for special products;
Process sales orders of special and standard products;
Make a production planning;
The responsibilities for the engineering department are:
Make a drawings for special products offers
Maintaining the ERP system
Furthermore, procedures should be made to accept or refuse orders.
2.2 Determining the cost price
In this paragraph, the sub questions 2a, and 2b will be discussed. The sub questions are determined as:
2a. What is the current method to determine the cost prices of NP?
part NP receives, namely 40%. The second part, 60%, is for the sales organization. In
Figure 2-1
the situation is being visualized.
Figure 2-1: Theoretical price distribution of normal products
This sales price distribution is being called the “intercompany price”. The catalog price is the price the customer has to pay to the sales organization (100%). The sales organizations keep 60% of the catalog price, and NP gets 40% of the catalogue price. History has learned that 40% of the revenues of all products of one month is enough to cover the production costs (material, labor, overhead, etc.) of NP.
The sales organizations are free to give a discount to the customer resulting in a lower margin than 60%. Even if the sales organizations provide a discount to the customer, NP keeps always the same intercompany price (40% of the catalog price).
Figure 2-2: Theoretical price distribution special products
As being visualized in Figure 2-2, the differences compared with standard products are the percentages. NP now receives 55% of the offer price because of the higher production costs. This results in that the sales organization receives only 45%. In general, the offer price of a special product is higher compared with standard products, and therefore the total amount the sales organization receives is higher compared with standard products.
In the paragraph “problem statement” became clear that the production costs of standard products were not covered anymore because of declining sales prices. The part NP receives depends on the sales price. This way of determining cost prices is at this moment outdated! The reason that the method is outdated is simple: NP does not know anything about the real production costs. There is only an indication that overall over all products 40% of the catalogue price is enough to make profit. In case of an economic crisis, the prices are dropping and with no adequate production costs information it is not known when to refuse an order. Therefore, the production costs should be calculated “bottom-up” so that NP knows if they will make or lose money on orders. By using the right “bottom-up” calculation method, NP receives information that is essential to increase costing knowledge about their products.
The offer price of special products in the current situation is based on estimates instead of a calculation. Of course, to determine the cost price for special products will always be an estimate because a special product has been never made before which will lead to unknown processing times, unknown material costs etc. However, it should become possible to base the production costs of special products on the production costs of standard products. The basis of a special product is always a standard product with extra features or other dimensions or color. If the calculated cost price of standard products will be used added with a rate, the way how the costs are calculated becomes more transparent.
When the cost price of standard products will be calculated instead of determined or estimated, the process variable of NP will change. The calculated cost price of standard products can be used in order to accept order or to refuse orders. Furthermore, the way how the cost prices will be calculated should be communicated to the sales organizations. This leads to a transparent way of working that is needed to create an understanding between the sales organization to NP and vice versa. This understanding is needed to let the sales organization and NP behave as one organization instead as two individual organizations with their own goals.
In the problem statement paragraph, some reasons for conducting this research have been discussed. One of the reasons was that there were rumors saying that the sales organizations order special products instead of standard products because a discount can be given to the
customer. However, after conducting a research about this rumor, the conclusion is that is does not make any sense to do this. There are two reasons for this conclusion. First, special orders are based on an offer. An offer price is always higher than a standard price from the catalogue. Thus, it will cost the customer more money to order a special product instead of a standard product. Second, the sales organization only receives 45% of the sales price instead of 55% of the sales price. Thus, the sales organization receives less money if a special product is being sold instead of a standard product. This leads to the conclusion that the rumor should be ignored.
Summarizing; in the current situation the share NP receives for manufacturing a product depends on the sales price. For special products this is 55% of the sales price, for standard products this is 40% of the sales price. Due to heavy competition of other organizations in the same market, economic situation and an increasing number of flex workers, the sales price drops, resulting in a lower amount of money for NP. Therefore, this situation affects the stability of NP. In order to optimize the situation, the cost price should be calculated instead of be a share of the sales price. The processes variable will be influenced because the pricing information that becomes accessible can be used to accept and refuse orders. Furthermore, the method how the cost prices are calculated should be communicated to the sales organizations so the mutual trust will increase that is needed to let the organizations act as one company with one goal instead of only contributing to their own goals.
2.3 Processes of NP
In this paragraph the sub question 3a and 3b will be discussed. The sub questions are determined as:
3a. What are the characteristics of the processes of NP and how can it be improved? 3b. How do the current processes of NP influence the stability?
The relevant processes of NP will be inventoried, and depicted with help of AAD. Furthermore, the way how the processes of NP influences the stability will be discussed.
2.3.1 Standard article offer and order processing
Figure 2-3: Processing standard offer requests
In general, before articles are being sold to a customer, the customer would like to know the price per order and, eventually, if a discount will be provided by the sales organization. Therefore, an offer (quote) has to be made. The processing of standard offer requests is visualized in Figure 2-3. For standard articles, making an offer is relatively simple and straightforward. First, a customer asks for an offer at a sales department. Next, the sales department will make an offer with the known prices which are accessible in the ERP system and in the catalogue. When the sales order is ready, the customer will be informed. The sales organization can provide a discount based on the type of customer (first time customer or regular customer), and the type of order (large order, or small order). In case if a discount is provided, NP does not receive less for manufacturing the product. This is because the share NP gets is a percentage of the catalogue price. How the “cost price” is being determined is already discussed in paragraph 2.2.
Figure 2-4: Processing standard sales orders.
First, the sales order will be submitted by the customer to the sales department. The sales organization will enter the sales order to the ERP system. The department “work preparation” of NP checks the ERP system two times a day for new sales orders. When new sales orders are present, the work preparation department will start processing the sales order. Processing consists of checking the bill of material (BOM). Check the routes (does the sales order has the right route through the factory?). This checking is needed because for some articles the BOM or the routes are not defined yet in the ERP system. The ERP system is not fully arranged for all products yet. If a BOM or Route is not available for that specific article, it will be added manually. The next step is to add the sales order to the general planning and planning per machine. Furthermore, in case if a production order requires processing on a special CNC machine, the CNC drawer will make drawings of this machine. The last step is to complete the production order.
2.3.2 Special article offer and order processing
The first step is the offer request of the customer to the sales department. The second is a feasibility request of the sales organization to the AMSP. The AMSP makes the decision if it is technically and financially feasible to proceed. If this is not the case, the offer will be rejected.
The processing of special orders does also differ from standard orders. The process is visualized in Figure 2-6.
Figure 2-6: Processing a special sales order
The first step of processing a special order is the same as standard articles: the special offer with a NP or AT number becomes a sales order and is added to the ERP system. At this point the sales price and the intercompany price are also entered in the ERP system.
workload for the department work preparation is increased, because sales order has to be processed manually, instead of automatically compared with standard articles. The work preparation department informs the AMSP that a special offer has been transformed to a special order. The AMSP will check the sales and intercompany price. Next, the engineering department is being notified about the special sales order. If a drawing was made during the offer process this drawing will be used and, if needed, one with more details and a “building plan” will be designed so the factory knows how to build the special product. When this is ready, the department work preparation will use it in order to make the production order.
Interviews with sales agents of the sales organizations and employees of the work preparation department emerges that three problems occur with processing of special orders.
The first problem is that the intercompany price is being inserted by the sales organizations as the sales price in the ERP system. This has as a result that NP receives only 55% of the intercompany price, instead of 55% of the sales price. For example, the offer price for 1 special product is 100 euro‟s. NP receives 55% of the offer price as being paid by the customer. The sales organization gets, therefore, the remaining 45%. In this case NP receives 55 euro. The sales organizations receives 45 euro. A mistake that is made very often is that the 55% that NP should receive is used as the sales price. This price only is used as the “intercompany” price. The customer just pays the normal price, but NP receives less money for manufacturing the special product. This leads to the next situation in case if the sales organization makes a mistake adding the sales price as the intercompany price. The sales price then becomes 55 euro. 55% of 55 euro is approximately 30 euro. This is a shortage of 25 euro! However, it is possible that these problems will be corrected in a later stadium by the AMSP.
The second problem that can occur is that the AMSP is not always being informed about special orders to check the sales price. A reason can be that the person responsible has a day off, is ill or forgets to inform the AMSP. If this is the case, the price won‟t be checked which results in, probably, a loss on that specific order for NP.
The third problem has to do with a technical problem of the ERP system. Even if the AMSP updates the order with the right data, this can become undone. When the special sales order is entered to the system, and mistakes are made with setting the discount and the sales price, as been discussed above, this will be resolved by the AMSP. However if, for example, the delivery date of the specific special sales order changes, the adjustments made will be changed back to their original state. If the change isn‟t noticed by the AMSP, because the change is made by the sales department, the old, wrong, data will be used.
The problems as mentioned above are affecting the stability of NP badly. Because the errors only occur by processing specials orders, the production costs will not be covered for these orders, which will result in a loss for NP. Concluding can be stated that the responsibilities as discussed in paragraph 2.1 are not performed optimal. Therefore, the processes should be optimized to solve these problems.
3. Design
In the third chapter, design, there will be a theoretical solutions presented in order to solve the problems as discussed in chapter two in order to increase the stability at NP. First, theory will be used in order to come to a solution. Second, the theory will be used to design a solution that is applicable at the NIG.
3.1 Structure of NP
In paragraph 2.1 became clear that NP should have the responsibility to accept or refuse orders became clear. It can be formulated as:
Who should be responsible for the new tasks and how should the procedure be designed? In the current situation, NP always accepts standard orders. This is because it is not clear if the production costs are covered because the exact production costs are never been calculated. In case of improving this situation, a procedure should be designed in cooperation with the sales organization that makes clear in which situations a sales order should be accepted in case of not covering the production costs. The current relation between NP and the sales organizations is discussed in paragraph 2.3. If considering standard products, the “virtual” margin is 60%. This margin is virtual because it is not clear if the margin is 40%. For some products the production costs probably will be less than 40%, thus NP gains money on that order, but it some cases it will be more than 40%, thus NP loses money on that order. Furthermore, as been said, the sales organization has a margin of 60% on all standard products. Conducted interviews with sales manager were saying that sales organizations needs at a minimum 30% margin, to break even. Concluding can be said that the sales organizations can provide a discount to the customer of 30% before it loses money. This illustrates that the margins are rather high at the sales organizations!
To design a procedure to accept orders when the production costs are not covered, the facts as mentioned above should be kept in mind. In case if a customer would like to buy standard products for a lower price, this should be possible under certain conditions. To give a person the responsibility to make such a decision the next should be taken into account. Essential in making the right decisions, is to transfer information. Agents involved in the decision making process should acquire information relevant for the decision to make. Transfer does not necessarily have to mean communication; it is about the effective transfer of information. In the case of NP, the transfer of knowledge in case of a special product is between the sales organization and NP, and in case of a standard product, between NP and the ERP system. According to Jensen (1999), this transfer of knowledge is a major problem in organizations. The problem with transfer of knowledge is that this will not happen instantaneous. It will cost (some) time to absorb the knowledge and will therefore cost money. Furthermore, it can be the case that it takes too much time that will lead to a complete loss of opportunities.
The right assignment problem is related to the degree of centralization in an organization. In highly centralized organizations, the management only is allowed to make decisions. In decentralized organizations, employees have the right (power) to make decisions by themselves. However, with this decentralization of decision making, another problem occurs. It might be possible that the rules of the organization are not aligned with the rules of the employee that has the power to make decisions. Therefore, there should be checked whether the decisions made by employees are in line with the organizations goals. The costs incurred in the conflict of interest are named control or agency costs. According to Jensen (1999), agency costs are “the sum of the costs of designing, implementing, and maintaining appropriate incentive and control systems and the residual loss resulting from the difficulty of solving these problems completely”. To prevent that the organizational goals are not aligned with the personal goals, the organization should design a set of rules that fosters everyone to agree with.
Figure 3-1: The trade-off between costs owing to inconsistent objectives and poor information (Jensen, 1999)
Jensen (1999) has visualized in Figure 3-1 a model of thinking about the trade-offs assigning a particular decision right to different levels in the organization‟s hierarchy. Jensen (1999) introduced five variables that will be discussed next.
Total organizational costs;
Costs owning to poor information;
Measures the costs of acquiring information and the costs of poor decisions being made
Costs owning to inconsistent objectives;
Measures the costs of acquiring information and the costs to owning inconsistent objectives
Distance of decisions rights from CEO‟s office;
Costs; Measures the costs
In order to determine the right degree of centralization there should be found a balance between the bad decisions because of poor information and bad decisions because of inconsistent objectives. In the case of a highly centralized organization (located at the start of the horizontal axis) the costs of owing poor information is high, while the agency costs leading to inconsistent objectives are zero. The cost related to owning poor information will drop when the CEO decides to delegate the decision right to other, most of the time, lower levels in the organizations. The costs will be lower because the decision right is exercised by agents having more specific knowledge to make the decision compared with the CEO. The optimum point is being reached when the value of the inconsistent objectives slope and the value of the poor information slope, added, have a lowest possible value (total organizational costs). However, the optimum degree of centralization depends, for example, on the size of the organization, the information technology used, the environment that is stable or unstable, the government relations and the control technology. Furthermore, if an organization grows, the costs of owing poor information and inconsistent objectives will increase. However, also information technology has a high impact on the transfer of specific knowledge. Improved information technology makes it, therefore, possible to transfer specific knowledge effectively between agents in the organization and even between the different levels in the organization. If this is the case, the organization becomes more centralized. Next, a summary of the differences between high centralization and low centralization is illustrated in Table 3-1.
High centralization Low centralization Decision making Management Employee
Alignment of goals organization High Low
Agency costs Low High
Decision making efficiency (right assignment problem)
Low High
Costs owning poor information High Low Table 3-1: High and low centralization compared
The problem of accepting or refusing orders can be applied by management, or by employees of, for example, the work preparation department. In case if management applies to this responsibility, this leads to a high centralizations which leads to less agency costs, but high costs of making wrong decisions because of owning wrong or poor information. Furthermore, if the work preparation department would apply to this task, the agency costs will be higher, but the cost of making wrong decisions because of owning wrong or poor information will also decrease. Because the agency costs are relatively low, only one person should have accept the task and the procedure of accepting or refusing orders, low centralization is preferred.
customers that would like to pay less than 70% of the sales price, some conditions should be designed. These conditions are stated next.
1. Customers willing to pay 70% to 100% of the sales price should be always accepted. NP receives always the cost price, and the sales organizations do not lose money on it. 2. In case if the price drops to less than 70% percent of the sales price, it becomes more
difficult to know when to accept these orders. First, NP loses money because the production costs are not covered anymore. Second, the sales organization loses money on the order. However at certain conditions it is still possible to accept the order. In the new method of calculating the “cost price” of products, the costs are based on an expected production. This expected production is, for example 1000 products a year. Furthermore, costs are based on fixed and variable costs. Fixed costs are, for example, employees and rent on buildings. Variable costs are, for example, material costs and labor hours spend on the product. The fixed costs are divided by the expected production, thus every cost price product is increased by a certain amount of fixed costs. However, if the production is above the normal production, more products will cover the fixed costs, thus more money is available to cover the fixed costs. If this is the case, products can be sold for less than the cost price. The only costs that should always be covered are the variable costs. The new method of calculating cost prices gives insight in the costs buildup, thus it becomes clear what the variable costs are.
3. To accept those orders, there should be an overcapacity at NP. If there isn‟t an overcapacity the best paying orders should be accepted only. Thus only customers whom will pay closest to a 100% of the sales price.
Essential for this procedure of accepting orders for customers that would like to pay less than 70% of the sales price, is to keep a record of the amount of sold products. The best is to do this is once a week. This leads to actual numbers of sales where the decision making can be based on. The work preparation department of the NIG should keep these records up to date. In the next paragraph, de design of the new process of accepting and refusing orders will be discussed.
Because the AMSP has already a lot of knowledge about prices of special products, it might be possible to make the AMSP responsible for accepting or refusing new orders. This is, however, incurring agency costs, because the AMSP goals should be aligned with the organization goals. In this situation the costs of owning poor information are minimal in case of a decentralized organization, thus these cost will be neglected.
In order to minimize the agency costs, both NP and the sales organization should accept the conditions as discussed above. Otherwise, the sales organizations do not know how the procedure is with reference to customers who would like to receive a large discount. For example, the sales organizations can sell products for a price that is below the cost price for NP while the normal production is not achieved, or there is no overcapacity. This leads to a sub optimization of the problem, and should be prevented. Furthermore, the AMSP should be aware of these rules and should also accept the rules to lower the agency costs.
The financial situation will be improved with implementing this procedures of accepting or refusing orders. The improved structure of NP will increase the process variable which will lead to the next situation as depicted in Figure 3-2.
Figure 3-2: The improved conceptual model
Summarizing; to sell products for less than the production costs some conditions are designed:
Customers willing to pay 70% to 100% of the sales price should be always accepted;
In case if the price drops to less than 70% percent of the sales price, at least the variable cost should be covered. Furthermore, the expected production is achieved;
There should be an overcapacity at NP, if 70% or less of the catalogue price is covered; Furthermore, NP and the sales organizations should accept these conditions in order to prevent sub optimization. In the case of NP the AMSP should be the one that should accept this responsibility because the AMSP has the best knowledge about products.
Cost price Processes
3.2 Cost price methods
The result of the diagnosis chapter was that NP should design a method to calculate the cost price instead of determine or estimate the cost price. The questions that were set in the diagnosis chapter are
What kind of costing methods are available and applicable for NP?
How can NP create a transparent way of working with reference to the sales organizations and increase the understanding between the organizations?
In this paragraph, an answer on the questions will be given. Next, the first question will be elaborated.
3.2.1 Standard Costing
There are a couple of costing methods available to calculate the cost prices of products. One of the methods is standard costing. Standard costing assumes that the flow of units is more or less continuous and products are somehow indistinguishable for one another. Because this isn‟t the case at NP, this method won‟t be discussed further.
3.2.2 Job order costing
Another costing system is job-order costing. The system of job-order costing is preferred when a diverse set of articles is produced. In a job-order costing system, costs are traced and allocated to jobs and then the costs of the job are divided by the number of units in the job to arrive at an average cost per unit (Garrison et al., 2006). The system of determining cost prices becomes more complex if the company sells a lot of different articles or services instead of only one item. Since the products are different, the costs are also different. Garrison (2006) discusses that there are three different kind of costs identified at job order costing, namely: direct materials, direct labor, and manufacturing overhead. The direct material costs are determined by the Bill of Material (BoM). Materials cost is an example of a variable cost. These cost changes as a result of the ever changing activities in the organization. If the activity increases (more articles produced), these costs will increase. However, if the activity decreases, less material is needed, and these costs will decrease. Furthermore, variable costs are classified in proportional variable costs, costs that grow linear with the activity, progressive increasing costs, cost whom are increasing more than linear, and defensive increasing variable costs, whom will increase less than linear with increased activity (Heezen, 2005). Next to variable costs, there are fixed costs. Fixed costs do not change when the organizational activity changes. For example, rent on buildings, and labor costs, because labor costs are only variable on the long term. However, in case of a bankruptcy this is, of course, not the case. In job order costing the rent on buildings is packed in the overhead costs and will be equally divided over all products. Next do direct costs there are indirect costs where no connection between the product and the costs exists. Indirect costs that cannot easily be traced directly to any job, like maintenance, supervision and clean up, are treated as part of manufacturing overhead. Assigning manufacturing overhead to units of product can be a difficult task. There are three reasons for this (Garrison et al., 2006):
Manufacturing overhead is an indirect cost;
Manufacturing overhead consists of many different items ranging from the grease used in machines to the annual salary of the production manager;
To overcome these difficulties, an allocation base should be used. The allocation base is used to compute a predetermined overhead rate. This allocation base is predetermined because it is computed before the period begins and is used to apply overhead cost to jobs throughout the period (Garrison et al., 2006).There are 3 different methods: the equivalence rating method, cost plus and the cost center method (Heezen, 2005).
The equivalence rating method (or normal costing method) reduces all products to one specific unit type. For example, conduits can be reduced to a cost per meter price, depending on the length and thickness of the used raw material. However, in order to determine this unit price, a production amount is needed. As approximation for the production amount can be taken the production of last year(s), the normal production or the budgeted production where, for example, the economical cyclical has been taken into account (Bhimani et al., 2008). When the production amount is been determined, the unit price can be calculated.
The cost plus method can be divided into two types, the single cost plus method or the multiple cost plus method. The single cost plus method states that there is causality between indirect and direct costs. The mark-up rate is, for example, being determined by dividing the expected indirect costs by the expected direct costs of labor. The multiple cost plus method determines the indirect material costs on bases of the direct material costs, indirect labor costs are based on the direct labor costs, and remaining indirect costs are based on the total indirect costs. The best method of these two methods can be determined by choosing the one where the indirect costs are best represented.
A third possible way to determine costs is using the cost center method. A cost center is a collection of all indirect costs that are related to a certain function in the organization. In order to assign the costs over multiple cost drivers, there should be determined which cost centers are generated. When all the indirect costs are assigned, it will be allocated to other cost centers. On this way, the direct costs can be allocated to the articles. The cost center method is mostly used at organizations that produce different articles.
However, when using these methods, some problems can occur. One assumption made regarding job order costing is that all overhead costs need to be assigned to the product and that these overheads relate (in most cases) to the amount of labour required to make the product. This leads to distortion of product costs. Some products appear to cost more than they really do and other products appear to cost less. The costs are misleading and cause wrong decisions to be made relating to pricing, profitability, make/buy decisions etc. (Maskel and Baggaley, 2004).
To overcome these problems, Activity Based Costing will be discussed next.
3.2.3 Activity Based Costing
In 1987 Johnson and Kaplan wrote a book with the title “relevance lost: the rise and fall of
management accounting”, wherein Activity Based Costing (ABC) is been discussed for the first
the activities that lead to traditional fixed costs, and access relevant costs did became easier (Cooper, 1991).
In order to adapt the ABC system, Corbey (2008) argues that the ratio between direct and indirect costs is important. If an organization has high direct costs compared with indirect costs, which are allocated already on the right way, it isn‟t recommended to apply ABC. The in that specific case, costs are already allocated in the right way anyway. Furthermore, Corbey (2008) also discusses the diversity of the products of an organization. Products can be classified in three different types, namely:
New and old products;
Standard and special products;
High and low volume products;
Corbey (2008) states that if the diversity in these types of products increases, it is worthwhile to adapt an ABC system. ABC does allocate the costs even better than the cost center method. Furthermore, Stratton et al (2009) argues that overhead costs, when using ABC, are accurately traced to cost objects in 70% of the companies. Of the non ABC users only 23% is accurately allocated. The cost price calculated with ABC is the cost price that is closest to the „real‟ cost price.
However, in order to successfully introduce an ABC system in an organization, Cooper (1990b) identified seven steps that should be executed, namely:
1. Seminar on ABC. Educate managers about ABC;
2. Design seminar. Educate managers about designing ABC;
3. Design and data gathering. Execute design steps (discussed next); 4. Progress meeting. Inform managers about progress made;
5. Executive seminar. Discuss other aspects of ABC implementation; 6. Results meeting. Discuss results;
7. Interpretation meetings. Discuss interpretation;
Step three consists of data gathering in order to design the ABC system. To successfully execute step three, the next steps should be executed (Innes and Mitchell, 1993).
Step 1: Identify activities. At ABC, work (actions and tasks) in an organization is split up in activities. These activities are the reason for the existence of indirect costs. These actions and tasks should be identified by conducting interviews with employees. The most important and time consuming activities should be listed;
Step 2: Costing activities. Assign costs to each activity. All indirect costs connected with an activity, are taken together as an indirect cost pool;
Step 3: Selecting activity cost drivers. Flowcharts of the paths of costs and processes an help to provide a clear understanding of costs and their behaviour;
Step 4: Allocate costs of activities to products. Activity costs are attributed to cost objects based on cost driver rates, which are calculated by dividing activity costs by the cost driver volume;
According to Innes and Mitchell (1993) four activity levels can be defined according to their cost behaviour in an ABC system, namely:
Unit-level. Costs that are directly related to the production volume;
Product-sustaining. Costs that are directly related to the production of each type of products;
Facility-level. Costs that are related to the support of the entire process;
Unit, batch and product level activities can be directly distributed to a product because ABC has made most of the costs direct, instead of indirect. However, the fourth activity, facility level, contains costs that are common to a variety of products and can only be allocated to products arbitrarily. An example of a facility level cost is the rent on buildings that has to be paid (Cooper, 1991). Facility level costs should be allocated by using the normal production (expected production)
3.2.4 Costing methods compared
In order to choose the “best” method, the costing methods will be compared on their characteristics and the applicability at NP, however, first will be discussed how much the different costing methods are used in the industry sector. According to Stratton et al (2009), ABC is used by the Industry sector in 18.3% of the cases. Job order costing is used in 23% of the cases and standard costing is used in 42% of the cases. The remaining percentage, 16.7%, uses no costing system at all.
The costing systems will be compared on three factors, namely complexity, accuracy and costs. These factors will be divided into two subfactors, namely for complexity designing and maintenance. For accuracy, fixed costs and variable costs, and for costs, designing and maintenance will be discussed. The factors will be transformed to statements so that each question can be graded using a Likert scale.
The statements will look like this:
Designing the costing system is easy;
Maintenance of the costing system is easy;
The costing system represents fixed costs on the right way;
The costing system represents variable costs on the right way;
The designing costs of the costing system are low;
The maintenance costs of the system are low;
The Likert scale to rate the statements is depicted next. The last number represents the points each answer provides.
Strongly agree (5 points)
Agree (4 points)
Somehow agree (3 points)
Disagree (2 points)
Strongly disagree (1 point).
First, the statements will be discussed for job- order costing (cost center method), next for ABC. Standard costing will not be discussed because it is already clear that it cannot be applied to NP.
Job-order costing system
Designing the costing system is easy;
The cost center method is based on cost centers. In order to know what the cost centers are, a research should be conducted. For example, the budget sheet gives information about the different costs and cost centers. Because it is relatively easy to identify the cost centers, four points will be given (agree) for the job-order system.
Maintenance of the costing system is easy;
When new costs occur, these should be allocated to the products who cause them. This is relatively easy because the costs can be added simple to a cost center. Therefore, this statement receives four points (agree).
The costing system represents fixed costs on the right way;
Job-order costing represents the fixed costs less accurate compared with an ABC system. This is because only cost centers are considered, not activities. Therefore, a cost driver rate like processing time or labour hours should be used to determine the fixed costs per product. This results in an estimation of fixed costs per product. However, at NP only 23% of the costs is fixed, and will not affect the cost price too badly. Therefore, the number of points received is only tree (somehow agree).
The costing system represents variable costs on the right way;
Variable costs like material costs are represented on an accurate way. The used material can be just calculated. Therefore, this statement receives five points (strongly agree).
The designing costs of the costing system are low;
Costs caused by designing a job-order system are low compared with ABC. Because the cost centers can be derived from the balance sheet, it takes by far less time than identifying all possible activities that is the case in an ABC system. Therefore, the statement is agreed (4 points).
The maintenance costs of the system are low;
Because the maintenance of a job-order costing system is rather easy, the costs are rather low. The system can be updated two or four times a year so, for example, the labour costs can be updated. This is a relatively simple and straightforward task. Therefore the amount of points earned is 5 (strongly agree).
ABC system
Designing the costing system is easy;
ABC is based on the activities performed by employees. To identify these activities, every employee should keep up a record of the activities performed. This is the case for operators, but also for managers and leads, therefore, to hundreds, or sometimes thousands of different activities. Furthermore, by designing and introducing successfully an ABC system even one or more seminars should be held. Therefore, it is difficult to design an ABC system. Because of this, the statement will be rewarded with one point (strongly disagree).
Maintenance of the costing system is easy;
