Kanthal Case

Executive Summary Over the years Kanthal has used its traditional accounting management system to cost its products. In 1985, when Carl-Erik Ridderstrale became president he developed the Kanthal 90 plan to increase overall profitability. He quickly recognized that in order to implement this plan a new account management system was needed to supplement the new strategy. In lieu of this need a new account management system was devised. Under the new cost system, two broad sources of costs were identified: manufacturing and SM&A. All costs within these categories were reclassified as either volume driven or order driven. Hence, four cost pools were set up. The implementation of the new system had some limitations and challenges: - The validity of the costing under the new cost system - The market dynamics and how they would impact implementation - Danger of losing customers for stocked items - The applicability of the new system across borders Moreover, the new cost system revealed that two large volume customers that were unprofitable. These customers were analyzed and recommendation made on the course of action. Introduction Kanthal is the largest of the six divisions in the Kanthal-Hoganas group of Sweden specializing in the production and sales of electronic resistance heating. Headquartered in a town near Stockholm, Kanthal has a product range consisting of 15,000 items supplying to about 10,000 customers. During the period of 1985 to 1987 it had steady sale revenue of SEK (Swedish Kroner) 850 million each year. Export sales accounted for 95% of total sales. Kanthal consisted of three divisions: Kanthal Heating Technology division supplied products like heating wire and ribbon, foil elements, machinery and precision wire. Kanthal was a world leader in supplying heating alloys with a market share of 25%. Kanthal Furnace Products produced a variety of heating elements for electric industrial furnaces. Kanthal was a prominent player within this market with a total market share of 40%. Kanthal Bimetals was one of the few companies at that time that manufactured fully integrated thermo-bimetals for use in the manufacturing of temperature controlling devices such as thermostats, circuit breakers and household appliances. Over the years Kanthal has used its traditional accounting management system to cost its products. In 1985, when Carl-Erik Ridderstrale became president he developed the Kanthal 90 plan to increase overall profitability. He quickly recognized that in order to implement this plan a new account management system was needed to supplement the new strategy. In lieu of this need a new account management system was devised.

This paper will aim to analyze the old account management system as well as the need for a new system for Kanthal 90. It will also provide some of the limitations of the new system and key implementation guidelines. Finally, the paper will address some of the consequences of implementation and responses to those issues. Old Account Management System and its problems: Under the old cost system, Kanthal used a simplistic approach to allocate overhead costs. The sales, marketing and administrative costs (SM&A) were applied to each product as a fixed 34% of sales revenue. This yielded a simple cost function: Cost of Product = Standard full cost of manufacturing + 34% (Sales revenue) In effect, all overhead expenses attributed to SM&A were pooled together and allocated based on a volume based driver, sales revenue. According to this system, if a customers sales price exceeded the full manufacturing cost plus the allocation for SM&A then that customer appeared to be profitable. Conversely, if the Sales price was lower than the sum of manufacturing costs and the allocated SM&A then the customer appeared to be unprofitable. This approach assumed that a product with higher sales revenue put a greater demand on SM&A resources than one with lower sales revenue. No attempt was made to link the SM&A costs directly to each customer order and gauge its individual impact on profitability. Under this system salespersons were compensated mostly on gross sales. Hence, under these conditions the sales and marketing effort put a lot of emphasis on sales volume rather than profits. Upon analysis, it came to the fore that the current system had some obvious drawbacks which motivated the need for a new system. Under the old system, it was assumed that all customer orders placed the same demand on the resources of Kanthal. This was not accurate as customers differed by: the level of technical and commercial service they required, whether they demanded standard or non-standard products and by their ability to forecast their demand. Because of these discrepancies, under the old cost system an order which placed fewer demands on Kanthals resources would be overcosted and appear to be unprofitable or less profitable than it was. This order would represent a hidden profit. Whereas, an order which placed a disproportionately large burden on the companys resources would appear to be more profitable than it was. This was a hidden loss order. Due to these hidden loss situations, many of Kanthals resources were employed towards unprofitable products and customers. New Account Management System: Motivation When Carl-Erik Ridderstrale took over as president at Kanthal, he put forward his vision for the company. He recognized that gone were the days when Kanthal would be satisfied with any business from big customers. Now, Kanthal had become established and in order to achieve higher growth and profitability it needed to refocus its attention. Therefore, Ridderstrale devised Kanthal 90 which specified overall profit objectives by division, product line and market. Kanthal 90 would seek to increase profits while maintaining a return on employed capital in excess of 20%. Ridderstrale wanted to achieve this without adding sales and administrative resources. He wanted to redeploy resources to more profitable uses. To achieve this, Ridderstrale recognized that it was important to distinguish customers according to the burden they put on the companys resources. For this to take place, the old accounting system was inadequate (outlined above). There was a need for an account management system which could accurately cost products and aid the implementation of the new strategy. This new account management system would allow the sales managers to accept responsibility for promoting high margin products to high profit customers. The need for a new cost system can be illustrated using the following calculations which contrast the new system vs. the old system. In Appendix #1, two customer orders with identical sales revenue are shown. Under the old system, they would yield the same amount of profit. However, applying the Kanthal 90 cost system, it is clear that non-stocked items place a greater burden on the companys resources than an order for a stocked

item. This translates into a 12.5% profit on the order for a stocked item versus a 100% loss on the order for an un-stocked item. The Kanthal 90 cost system recognizes the cost differential between stocked and un-stocked items and costs orders accordingly. Similarly, Appendix #2 shows two customers with identical sales revenue but with differing frequency of orders. Customer A places just 3 orders whereas Customer B places 28 orders (6 stocked items and 22 un-stocked items). Under the old cost system both would seem equally profitable. However, Kanthal 90 recognizes that each order places an additional burden on the companys resources with orders for un-stocked items having an additional cost associated to them. New Account Management System: Features In order to devise a new account management system a company wide analysis was done to extract the nature of the support activities performed and the best way to allocate them. Traditionally, Kanthal treated SM&A costs as period costs and made no attempt to allocate them to individual products or customers. Based on the findings, two broad sources of costs were identified: manufacturing and SM&A. All costs within these categories were reclassified as either volume driven or order driven. Hence, four cost pools were set up. This yielded a modified cost function under the new system: Cost of Product = manufacturing volume related costs + manufacturing order related costs + SM&A volume related costs + SM&A order related costs This was in effect a move towards an activity based cost system (ABC). The allocation of costs made it explicit as to how the costs were related to different orders and products. Hence, it provided valuable information about activities and an objective measure of assessment for those responsible for these activities. This was in line with the change in strategy and would facilitate the implementation and evaluation of Kanthal 90. Moreover, it would assist in identifying cost behavior relevant to different products and hence help price them more accurately. The mechanics of the new system followed four steps: SM&A Order costs: SM&A order costs per order were determined by dividing the total selling and administrative order costs by the total number of orders Manufacturing Order cost for Non-stocked items: Calculated by dividing total manufacturing order costs by the number of orders for non-stocked items. SM&A Volume costs: Total volume costs were calculated by deducting order costs for non-stocked items and SM&A order costs from total manufacturing and SM&A costs. Allocation factor was determined to apply SM&A volume costs to cost of goods sold. Operating profit: Operating profit was determined by deducting the volume related and order related manufacturing and SM&A costs from sales revenue. Limitations: Kanthals move to an ABC system was in line with its goal of identifying and re-deploying resources in more profitable areas. However, this change may have some limitations which can compromise its effectiveness. The cost information used to estimate the activity value drivers are based on past data. Using this method casts a shadow over the accuracy and validity of these drivers. This method assumes that these costs will behave in the same manner in the future as they have in the past. This may or may not be true and will affect the effectiveness of the output from the new costing system. In essence, the usefulness of the drivers is highly dependent on the validity of the data used. Kanthals initiative to implement a new account management system was brought about by a change in strategy. The new accounting system will help identify unprofitable customers who have thus far appeared to be profitable. Therefore, the redirecting of resources to profitable customers should be obvious. However, there

are two points of contention here. Firstly, the underlying assumption seems to be that there are profitable customers in the market willing to purchase Kanthals products. We do not have sufficient information about market dynamics to conclude that this sort of opportunity exists. Kanthal already commands a sizeable market share in two of three divisions it runs. Hence, to replace 60% of its customers will not be a straightforward task. This is a dangerous assumption to make. Secondly, if Kanthal chooses not to supply to unprofitable customers and is unable to redirect these resources to profitable customers then this will impact its cost structure. As of now the fixed costs are being spread over a large number of units due to the volume sales provided by large customers. However, a sudden reduction in production volume will increase this per unit allocation of fixed costs. In effect each unit of production will have to bear a greater burden of these fixed costs. Previously, due to the high volume of production, relative economies of scale were experienced as these fixed costs were spread over a larger volume of production. In essence, the cost economies experienced were predominantly due to the large customers who purchased a large number of units. The cost economies experienced as a result of these high volume products had the effect of subsidizing the low volume products. Therefore, discontinuing sales to these large customers will reduce these cost economies and may lead to a reduction in profit or even a loss on the other products. The case points out that only 20% of Kanthals products were stocked in inventory, but these products represented 80% of sales orders. This statistic seems to point to the fact that most of the high volume customers purchased products that were mostly stocked. If the customers that will replace these existing customers do not have the same product preferences, there will be two effects. Firstly, there may be an increase in sale of products that are not stocked and as the calculations shows products that are not stocked have a substantially lower profit margin. Secondly, this may in the long run require Kanthal to increase its offering of stocked products thereby increasing its holding costs of retaining them in inventory. In this case, the management through the new system will not necessarily add profitable customers to Kanthal. Kanthal has international operations with manufacturing facilities located in 6 different countries (Sweden, Brazil, U.K., United states etc.). However, all the data used in developing Kanthal 90 pertains to the Swedish operating divisions. Kanthal 90 identifies order costs as a substantial expense and separates the cost into different cost pools based on that. Implementing Kanthal 90 as it is may not yield the desired benefits owing to local differences. Other international operating divisions may have other costs that are more important to them. For instance, holding costs maybe more of an issue than ordering. Hence, a detailed analysis, similar to the one conducted in Sweden, would have to be carried out at each manufacturing unit. Implementing the plan as is may not be effective and fail to achieve the desired goals. Implementation Issues: The implementation of an ABC system has put forward some startling revelations; none more so than the fact that 60% of all customers are not profitable. However, just pure numbers do not reveal the entire picture and there are other pertinent intangible considerations that need to be looked at. The ABC set up has revealed that two of Kanthals largest volume customers are not profitable. These two customers are important players in the market and in the past Kanthal has welcomed any and all orders from these parties. Clearly, Kanthal would want to continue this working relationship but on better terms. Hence, it is imperative that this relationship be managed properly. Further investigation has revealed that both these customers have moved to a JIT (Just In Time) system which pushed the burden of inventory on Kanthal. Moreover, one of these customers uses Kanthal as a back up supplier. Both these situations have increased uncertainty regarding the timing of orders and as such made demand forecasting impossible. Furthermore there are uncertainties regarding not only the volume of units demanded but also the type of products (stocked vs. non-stocked) being ordered. It is clear that non-stocked products are inherently more expensive to Kanthal than stocked items. Therefore, Kanthal should look to negotiate terms with these customers and urge them to purchase more stocked items. Asking customers to increase the size of their orders would be another option in normal circumstances. However, considering these two customers have moved to a JIT system this would not be an option for them.

Kanthal should look to negotiate an increase in price for non-stocked items. These products put an extra burden on Kanthal and should be priced as premium products. This will help recover the losses that occur because of the ordering of non-stocked items. Moreover, this will signal to the customer that there are greater manufacturing complexities involved and as such Kanthal would like a premium for it. This measure also has the added benefit of, revealing how much value the customers place on these non-stocked items. If there is significant value, they will be willing to pay the premium. However, if the value differential is trivial they will likely alter their operations and shift to lower priced stocked items. Conversely, the customers may divert their business to a competitor who can offer the same product at a cheaper price. This may lead to loss of sales and profitability. One important consideration here is that Kanthal acts as a backup supplier to one large customer. If it is able to satisfy this customer, Kanthal may be able to secure this high-volume opportunity in the future. This may be a factor in Kanthals negotiation with the customer. In such a situation, a price increase will not be regarded favorably by the customer as Kanthal at this point is not a major supplier to them. This customer may likely divert their business as soon as such an assertion is made. Kanthal may wish to deal with this situation differently and be willing to absorb some losses in the short term as trade-off for a larger volume of business in the long run. This will depend on Kanthals managements judgment and their assessment of their working relationship with the customer, and whether they deem a short-term loss to be a fair trade-off for greater long-term profitability. With the change in cost system, Kanthal should look to realign its incentive program to make better use of the ABC system. Previously, sales personnel were compensated based on sales volume, this should be changed to how much each order or customer contributes to the bottom line. This would align the incentive structure with goals of Kanthal 90. Conclusion: Kanthal should not view the change in accounting system in isolation and use it for company wide demands for a price increase. Kanthal should ensure an activity based costing structure facilitates activity based management. Through activity based management, Kanthal should look to control its various cost pools, in particular, order costs. The manufacturing order costs for non-stocked items are substantial. This cost should be scrutinized and an attempt should be made to reduce them. A reduction in the cost pool will reduce the per order cost of non-stocked items and make them profitable. Moreover, reduced costs will also benefit stocked items, thus improving profitability. The new accounting system has laid the necessary groundwork and highlighted areas for improvement. Kanthal should focus on these findings and act upon them. Meanwhile, in the short run they may choose to improve profitability by concentrating on profit maximizing orders.