Anagene Inc.Group Assignment ..........................................................................................................................................3 Background................................................................................................................4-7 Major Issue Identification................. 13-15 Recommendation and Conclusion..................................................................... Table of Contents Executive Summary...........................9-13 Sensitivity and What-If Analysis.........................................................7 Key Success Factors and Constraints.............................................7-9 Alternative Generation and Analysis............................................................................................................................................15-16 Appendices: Calculations............................................................................................................................................................17-19 2 ................................................... which makes it difficult to understand profitability. therefore the denominator should represent the quantity of work the resources can perform. This method stabilizes their gross margins as well as increases their margins by charging a more accurate and representative price for the cartridges. It is important to understand the nature of the external environment the company is operating within. The company’s main operations are now narrowed down to their work stations and cartridge sales. Furthermore. they can assign fixed overhead costs per unit based on budgeted production or practical capacity. continuous changes in an emerging field has made it difficult to assess costs and give investors a clear insight on projected sales. There are three alternative ways to solve this problem. gross margins have been fluctuating accordingly. The company has found an opportunity in this new niche market and has shifted its focus from research and development to manufacturing research applications. Anagene Inc. with large fluctuations occurring and limited information on hand. since product costs have been unpredictably fluctuating from month-to-month. Moreover. After a thorough evaluation of the alternatives. Even though future trends are forecasted to be optimistic. The genome field is relatively new and with many breakthrough technologies entering the industry. the company is “still feeling their way in the dark. as it has leveraged microelectronics in its microarray design. 3 . However.Executive Summary As expansion has been the main focus for Anagene Inc. it is suggested that Anagene allocates its fixed overhead costs based on practical capacity because the numerator in an activity cost driver rate calculation represents the costs of supplying resource capacity to do work. can choose to not assign fixed overhead costs by using the contribution margin approach. is that the margins for cartridges have been decreasing and standard costs have increased about 40%..” The main issue faced by Anagene Inc. the company has seen success. Firstly. Tubes of DNA samples are examined on the microchip. gene discovery work based on large populations and large volumes of 4 . The process is run by a Molecular Biology Workstation which consists of four cartridges that facilitates gene screening. On one end there is industrial genomics: large-scale sequencing. External Environment The market of genomics is a wide spectrum. a reader and a disposable cartridge that contains the company’s proprietary microchip.Background What is Anagene? In 1993. operating in an emerging market. Anagene’s product focused on patient-oriented genomics as the cartridge had been designed for low volume applications and produced very accurate results. Anagene emphasizes on the accuracy of technology. PhD in biochemistry. The demand for the cartridge replacement has become Anagene’s target market. the cartridges need to be replaced in order to maintain test accuracy. Value Proposition Anagene’s sale’s team’s main focus is to deliver solutions on customer’s toughest assays. Mission Anagene’s mission is to facilitate breakthrough genetic analysis. a serial entrepreneur well known in the biotechnology field. Anagene was founded by Mark Hansen. Anagene is an established. matching and analyzing. Due to wear and tear. and Harold Bergman. publicly exchanged bio tech company that focuses on genomics instruments. Anagene’s First Major Product Anagene’s main product is the Molecular Biology Workstation. This workstation includes a loader. accuracy is the key to determine efficacy and safety of drugs for individual patients. thus increasing competition and crowding the market. which is based on clinical research on individual genes. On the other end. such as Anagene. Anagene’s product was considered extremely accurate with several beta sites. For patient-focused genomics. Anagene leveraged microelectronics in microarray design. This market has demonstrated a large potential payoff. Anagene also began establishing strategic relations and collaborations with other companies to gain access to global markets without having to shift limited resources away from development and sales. Unlike its competitors. Beyond this market. The market for DNA microarrays was large and projected to grow to $4. industry analysts believe that Anagene’s technical approach to design and use microarrays is a competitive advantage. have achieved revenue from two major sources: equipment sales and follow-on sales of chips or cartridge. where tens of thousands of patients may be analyzed. Stakeholders 1. Kelly must explore alternative methods for calculating product costs and gross margins that would represent long-run performance. which acts as an incentive for several companies to enter the DNA microarray market. giving users the ability to localize probes and samples at specific predetermined sites. Despite this. there is patient-focused genomics. and will work with Anagene’s controller to look into the causes of fluctuating and unpredictable margins.5 billion by 2004. Kelly does not believe that Anagene’s business fundamentals changed radically from month to month. where accuracy is vital but not necessary. President and CFO of Anagene: Kelly is currently being questioned by the Board for the 40% increase in standard costs for the company’s main product line: Anagene cartridges. Market participants. 5 . Gerald Kelly. In addition.data. and reduced transfer costs. Anagene discovered that some customers were reusing disposable cartridges rather than ordering new ones 7.2. 3. 5. They should also work on getting the support of top management in the new suggested recommendation to ensure support and commitment to future budgeting and decision making. Finally. they should continue on marketing the importance of cartridges being non-reusable. Qualitative Focus Whichever alternative that Anagene chooses. Anagene should make sure that they advise shareholders and keep all stakeholders informed on this necessary action to 6 . Hitachi will take over final quality control and ship directly to customers. Analysts wanted predictability for gross margins. Investor community: the higher unit cost and reduced margins will be unattractive to investors. Industry analysts: They would examine Anagene’s quarterly gross margins closely as they built business models to predict future profits. Anagene plans to work with Hitachi to cut costs through value engineering. There is a possibility that over time. Board: The board is seeing a problem persisting into the 2001 year: shifts in product costs and gross margins are unpredictable (higher unit costs and reduced margins). Global relations: Anagene needs to be a predictable company to maintain strategic relations and collaborations with global companies. Hitachi Ltd (Supplier): Anagene outsources to Hitachi for production of the loader and reader components of workstation. as to increase sales. Customers: Customers use Anagene’s disposable cartridges and work stations. 4. 6. Anagene needs to calculate product costs and gross margins that would be representative of long-run performance and to help management make better decisions. lies in its standard cost calculation. Secondly. Currently. analysts find it difficult to project future sales. gross margins have been fluctuating accordingly. Anagene uses projected demand as the basis for budgeted volume. which makes it difficult for board members and analysts to understand the short-term profitability. Therefore. losses have been reported on Anagene’s budgeted income statement for the past few periods. (50000 to 26000). to evaluate their profitability under their standard cost estimation method. which raises serious questions about the long-term profitability of the business. As a result. Moreover. Since the genetics market is growing rapidly and the number of customers is greatly increasing. cartridge margins have been decreasing and standard costs have increased about 40%. This will increase a sense of ownership among stakeholders as well as make the implementation of this necessary action run more smoothly. which greatly impacts the pricing and stability of gross margins as Anagene’s sales fluctuate. sales forecast was adjusted down by 24000 units. which pose a problem for Anagene Inc. which 7 . since product costs have been unpredictably fluctuating from month-to-month. This gives Anagene a competitive advantage. allocated fixed overhead costs per unit and gross margin fluctuate in the long run. Firstly. industry analysts believed that Anagene’s technical approach to the design and use of microarrays was innovative and effective. Although the market had many suppliers. As the budgeted volume is volatile.ensure support and minimize any rebellion. Key Success Factors and Constraints Market for DNA microarrays was dynamic and growing as participants generated large volumes of revenues from sales of chips or cartridges. Major Issue Identification The major issue faced by Anagene Inc. providing a strong base for future cartridge sales. it fails at allocating fixed overhead costs which creates an unstable trend for gross margins. The higher unit cost and reduced margins would affect investor community since industry analysts would examine Anagene’s quarterly gross margins closely as they build business models to predict future profits.” which gave Anagene further competitive advantage amongst competitors or other suppliers. unlike its competitors.may allow it to charge a higher price. However. Analysts expected predictability and Anagene’s gross margins had not been 8 . Anagene also accelerated the use of non-title transfers so that the company’s technology could be adopted quickly across different markets. expected the demand for cartridges to increase rapidly. Anagene’s technical representatives helped companies develop their most difficult assays. Moreover. They also began to establish strategic relationships to access global markets without having to shift its limited resources away from development and into sales. it cannot charge a price too high to decrease demand drastically. as it gives users the ability to localize probes and samples at specific predetermined sites. Another strength is that Anagene’s products are considered to be extremely accurate and the accuracy has been proven by several beta sites. Despite the fact that Anagene’s product has many competitive advantages. Due to these strengths. Anagene leverages microelectronics in its microarray design. thus affecting sales and profitability of the business. Anagene ships its cartridges without any DNA attached. In contrast. because Anagene does not have a monopoly and the demand for its cartridges is elastic. which allows customers to put down whatever they wanted to study. Moreover. most competitors sold their chips “pre-spotted” with “massive arrays of DNA. and as a result. Anagene sold more workstations. This could potentially harm their products further as it would decrease the demand for their products as well as sales In 2001. These serve to be threats to Anagene’s profitability. may force Anagene to discontinue production if great losses are incurred. customers had been reusing the disposable ones. Ignoring fixed overhead would affect Anagene’s pricing strategy as Anagene may set prices much lower than the actual costs incurred.predictable. Moreover. forecasted sales had to be revised from 50. Alternative Generation and Analysis Qualitative and Quantitative (Internal. Financial) Alternative 1: Do not assign fixed overhead costs at all or use contribution margin that only takes variable costs into consideration Overhead cost allocation is crucial because it affects gross margins and provides a more accurate value of costs associated with the production of each product. rather than ordering new cartridges for each experiment. it is important to note that GAAP is not a constraint because these costs are being used for internal decision-making. it is not recommended to ignore fixed overhead costs as they affect the company’s profitability and in the long run. Also. Lastly.000 to 26. External. The variable contribution margin method 9 . Therefore. which led the installed base to be smaller than projected. the ramp-up of workstation sales had been slower than expected in 2000. It also limits managers from understanding the probability of idle capacity and does not allow them to make decisions holistically as it constrains the production process.000 units because sales lead time had been longer than originally estimated due to differences in the length of time required by difficult assays. which would cause great losses. 000 as opposed to the 50. Fixed overhead costs per unit are currently updated only once a year. Since Anagene is in an emerging market. Since the cost depends on budgeted volume (sales forecast). Alternative 2: Divide the allocated overhead costs by budgeted production/manufacturing Fixed Overhead volumes to obtain an overhead cost per unit [Overhead cost per unit = Budgeted Production] Current way of allocating OH Anagene Inc. This was because of the lower anticipated cartridge production volumes of 26.would be most effective for Anagene if there was a short-term price change such as a special order that would constitute a different price than current price of $150. where sales vary dramatically from month to month. is currently calculating its product costs by allocating overhead costs based on budgeted production volumes. therefore. The dynamic market condition and limited information have raised standard costs by 40% and gross margins to drop from 65% to 45%. 10 . such aggregate and infrequently updated information was not very useful for production cost control.000 forecasted sales which caused the overhead cost per cartridge to increase. a decrease in the sales forecast would cause standard costs to increase as well as increase volatility in margins from month to month. forecasting sales is very difficult to do. The only advantage of using this approach would be that it will allow Anagene to hide its idle capacity as budgeted volume is based on demand instead of production capacity. If plant level overhead costs are fixed in the short-run and management uses forecasted activity levels to calculate cost driver rates. has contracts and commitments to acquire resources. Lower actual sales cause a death spiral or vicious cycle which may be very harmful to the business and its operations. managers may want to maintain the current level of resources in order to handle the higher-than-expected order volumes in the future. The numerator in an activity cost driver rate calculation represents the costs of supplying resource capacity to do work and the denominator should represent the 11 . This is done by better recognizing the capacity of the resources being supplied. Customers would search for substitutes which would further decrease sales and lead to even lower activity levels. Lower activity levels would then be used again to calculate cost driver rate. Cost driver rates should reflect the underlying efficiency of the process. higher cost drivers may lead management to set higher prices which in turn would reduce demand. which means that plant level overheads costs cannot be reduced in the short run in response to lower activity levels. thus these costs are fixed. As these costs are used for internal decision making. activity cost drivers will increase if activity level declines due to slowdown in economic activity or loss of a major customer. Alternative 3: Divide the allocated overhead costs by practical capacity to obtain overhead cost Fixed Overhead per unit [Overhead cost per unit = Practical Capacity] Another alternative is to calculate the overhead costs per unit by dividing the allocated overhead costs of cartridges by the practical capacity. The problem arises because Anagene Inc. which would be even higher in the next period. Furthermore. using the practical capacity to allocate fixed overhead costs allows Anagene to maintain higher gross margins compared to using budgeted volume. using practical capacity will also allow Anagene to manage production costs in a more efficient way by maintaining an efficient budget as well as identifying constraints that affect the production process. This will allow them to maintain their demand as prices will not be affected by fluctuating costs and maximize their profits. Practical capacity takes into consideration production levels in the long run. This will allow Anagene to reduce allocated fixed overhead costs per unit. The estimated overhead amount is $1. Using the full practical capacity as the cost driver will allow Anagene to lower its allocated overhead costs per unit. and increase the gross margin while keeping current prices.299.581 and the rate is 12 . This alternative is essentially utilizing the pre- determined overhead rate method. Assuming that Anagene’s full practical capacity is stable in the long run. which is more appropriate for estimating production levels. thereby increasing gross margins. This will allow them to minimize idle capacity. Practical Capacity method for calculating OH As seen above. Moreover. allocated fixed overhead costs per unit and gross margin per unit will also be constant.quantity of work the resources can perform. In the case of Anagene. this seems to be a more appropriate way of allocating overhead costs because Anagene is in an emerging market where demand constantly fluctuates and so do product costs and gross margins. The opposite will happen if Anagene sells more than its practical capacity. but the forecasted sales for 2002 are 95. If Anagene sells fewer units than this amount then the applied overhead cost will be greater than the actual overhead cost which will result in a credit in the overhead cost account so that it equals actual overhead cost. Therefore. The only downside of using this approach would be that it reveals the company’s operating potential. management will make use of practical capacity to do the sensitivity analysis.$25. identify idle capacity as well as set prices that are more representative. Due to the fact that Anagene expects future demand to grow as the cartridges will no longer be reused.300 units.300 units. Sensitivity and What-If Analysis 13 . using practical capacity as the basis for allocating fixed overhead costs will allow Anagene to better manage their business as they will be exposed to and will have a better point of view about stocking up inventory to meet future demand.33 per unit based on a practical capacity of 51. Current production capacity level is only 51.000 units. This means that Anagene will have to stock up inventory to meet future demand. at the end of the 14 . As a result. This will also allow them to set appropriate prices as to ensure they are able to cover their costs and are able to accomplish their objectives as a company. Anagene would have to wait until the end of the fiscal period to know a more accurate magnitude of fixed overhead incurred. By continuing on with the budgeted sales approach. Anagene cannot accurately estimate their overhead cost per unit ahead of time as they are in an emerging market. and therefore. Under these circumstances. As seen in the income statements above. the gross margins fluctuate widely. they will know the magnitude of their profits. Then. they will be able to determine a more accurate overhead rate per unit ahead of time (or a POHR (pre-determined overhead rate)) which will allow them to estimate manufacturing overhead costs sooner. the practical capacity method maintains a relatively constant gross margin of 62-63% but under the budgeted sales approach method. which has resulted in losses as they fail to cover their fixed costs. cannot accurately estimate sales. there is too much unknown. would benefit greatly by accurately knowing what their gross margin will be as that will allow them to be more aware how many units they need to sell to cover their fixed costs. Anagene Inc. under various sales that do not exceed the practical capacity (to make the comparison more simple). If Anagene Inc switches to the practical capacity approach. This does not allow Anagene to set representative prices. which will enable Anagene Inc. resulting in a decrease in demand. and a debit in the inventory account so that the overhead cost equals the actual cost of overhead incurred in the fiscal period. which offers upper management better understanding about the company’s current performance and facilitates them to make future production plans. Using practical capacity approach reduces allocated overhead costs.fiscal period. Anagene Inc. Recommendation and Conclusion Anagene Inc. The overapplied amount requires a credit in the overhead cost account. the applied overhead cost was greater than the actual overhead cost which resulted in an overapplied amount for overhead at the beginning.299. **Assumption: $1. continues using budgeted production to calculate the fixed overhead costs per unit.581 is the applied OH in this scenario Under all of the different sales examples. is a part of an emerging market which means that demand will fluctuate from month to month. they can see whether their estimate was overapplied or underapplied and adjust the overhead account accordingly as seen below. 15 . to maintain a higher and more stable gross margin at current prices and in turn maintain demand. the practical capacity method will indicate the idle time. If Anagene Inc. This makes using practical capacity as a cost driver beneficial since the overhead cost per unit will be maintained at a constant level. should calculate fixed overhead costs per unit based on practical capacity instead of budgeted production. This also increases gross income as well as net income. Moreover. they will fall into a spiral where they will have to repeatedly increase prices to maintain their current margins. to look into constraints in production. The sales forecast for 2002 is 95. If Anagene Inc. prices will be increased.000 but the current practical capacity is only 51. In conclusion. In addition. However. They will also be able to adopt a better pricing strategy as they will be aware of truer costs of each product. resulting in a decrease in demand. 16 . To increase practical capacity. Doing so will allow them to enhance production processes as management will be able to identify constraints and minimize idle capacity. In that case. Anagene may want to allocate fixed overhead on the basis of direct labour or direct labour hours. it is important to note that doing so will be beneficial in the long run. In the future. Anagene Inc. tries to keep profit margin consistent with the previous year without reaching its full practical capacity. practical capacity gives the company a better structured budget and enables Anagene Inc.300 as it is constrained by permeation layer deposition and thickness testing. Anagene aims to implement new production techniques and machinery like the automatic spin coater. if Anagene plans to implement this technique. but will not be relevant for the year 2002. they may have to hire more employees. This strategy is more likely to attract investors which will be crucial for Anagene's future. should switch over to using practical capacity as it is in an emerging market. Appendix A: Fixed Overhead Calculations 17 . Appendix B: Income Statement Calculations 18 . Appendix C: Income Statement (What-if and Sensitivity Analysis) Calculations 19 .