Michael G. Foster School of Business Danish Premium Ltd.* Danish Premium Ltd. is a food manufacturer based in Copenhagen. It prepares, packages and...

Michael G. Foster School of Business

Danish Premium Ltd.*

Danish Premium Ltd. is a food manufacturer based in Copenhagen. It prepares, packages and distributes branded vacuum-packed meat, cooked and uncooked, and other food products. Vacuum packing is popular in Europe because such products have a long shelf life without requiring sub-zero temperatures. This compact packaging format is economical for manufacturers, distributors and customers alike.

For many years Danish Premium had sold vacuum-packed sliced beef brisket in gravy, a very popular dish in Denmark. In 1998 the product represented about 15% of the firm's total sales in a product line, which comprised 30 products. The Danish homemaker very often serves this dish together with a red cabbage salad. Because this salad is rather time-consuming to prepare at home, certain competitors of Danish Premium had recently introduced ready-made red and green cabbage salad in spicy mayonnaise (commonly known under the generic name of coleslaw) in either refrigerated vacuum-packed or frozen form. However the major part of the coleslaw consumed was still prepared at home. Although sales of ready-made coleslaw were expanding rapidly, it was confirmed by consumer research that there was still a great, untapped potential for such a product.

At the beginning of the second half of 1998, Danish Premium had still not entered the vacuum-packed coleslaw market. But in view of existing market potential, and since it was so often eaten together with sliced beef brisket, company management considered introducing vacuum-packed coleslaw in 1999. Danish Premium was also considering introducing a specialty line of complete meals, which were to be sold in an attractive carton containing two vacuum-sealed bags with the different components for the meal. The management decided that the first product in this specialty line was to be "sliced beef brisket in gravy with coleslaw" which will be called "Family Pack" in this case. The product was to be packed in a carton containing the standard vacuum-sealed bag of sliced beef brisket plus another bag with the coleslaw. Cost allocation problems arose in this connection, leading to long discussions between the marketing and finance departments of the company.

The standard product, "sliced beef brisket in gravy" or "Meat Pack," was sold in a 450 gram bag at a consumer price of € 4.851. This was the "ideal" quantity for an average family, giving between 3 and 4 servings. Therefore, when considering the "Family Pack" product, the marketing department did not wish to change the quantity of sliced beef brisket in gravy. Extensive testing showed that the average family consumed between 500 and 600 grams of coleslaw with 450 grams of sliced beef brisket in gravy. It was therefore decided to sell the "Family Pack" product in a one-kilogram pack, containing the standard 450-gram bag of sliced beef brisket in gravy plus another vacuum sealed bag with 550 grams of coleslaw.2

The marketing department received a preliminary selling price recommendation from the finance department, based on the assumption that the new product should produce approximately the same profit per kilogram as the standard beef brisket in gravy (i.e., € 0.30 per kilogram as shown in Exhibit 1).

The difference in consumer price between the two packs as proposed by the finance department meant that the consumer would have to pay € 3.35 (i.e. €8.20 - €4.85) for the coleslaw, since the sliced beef brisket in gravy content of the two packs was the same. The marketing department protested that this price difference was prohibitive, since the ingredients for making the coleslaw at home could be bought at retail for approximately € 1.10 and the labor costs at home (if counted at all) would not amount to more than approximately € 0.70. The marketing department argued that Danish Premium could not expect the consumer to pay more than € 2.00 for the coleslaw and added convenience. The marketing department thus viewed the maximum consumer retail price for the new pack as € 6.85 (i.e. 4.85 + 2.00). Furthermore, the marketing department emphasized that, since the finance department's selling price calculation showed that the raw material and labor costs amounted to only 0.75 for the coleslaw, it was unreasonable that the addition of the salad to the meat should result in a total consumer price difference of € 3.35 (i.e. 8.20 - 4.85).

The marketing department then proposed its own price calculation, based on the assumption that the consumer price for the "Family Pack" would be € 6.85 as indicated above (see Exhibit 2).

There was no disagreement between the marketing and finance departments with regard to the raw material, labor, packaging material, transport and storage, and sundry other variable costs. The item "Other product-related fixed expenses" covered mainly advertising. Consequently, the marketing department could not argue with the finance department about this item either, since it was under the control of the marketing department. The two items "Margins and discounts" and "General overheads" are, as a standard rule in the company, calculated as fixed percentages of the price to the retailer (8% and 4%, respectively). Although this procedure might be open to question, the marketing department was satisfied that the costs allocated to this product would decrease automatically if a lower selling price could be agreed upon.

Thus, the main discussion centered upon the item "Production fixed expenses." After internal agreement on the sales budget every year, the total production fixed expenses were divided by the total sales quantity, expressed in kilograms. This computation had resulted in a rate of € 1.20 per kilogram for the year 1999. This rate was then applied to all products from the company's factory.

The coleslaw could be prepared using existing equipment and labor with only minor adjustments. There was spare capacity available for the estimated production of the new "Family Pack" product. The estimated sales of 85 tons of the new product had been included in the budgeted sales quantity for 1999.

The finance department claimed that any departure downwards from the rate of € 1.20 per kilogram for the absorption of production fixed expenses would result in an under coverage of fixed expenses. The marketing department replied that a strict application of this rule would lead to unreasonable consequences in this case, where a relatively cheap component (red or green cabbage) is added to an expensive component (sliced beef brisket in gravy), and where the cheap component more than doubles the weight of the new pack and thus also doubles the fixed overhead charged to the product. The finance department stated that it would be impractical to use different overhead rates per kilogram for different products. The Chief Executive Officer supported this position in saying that no product should be introduced if a normal selling price calculation did not show a reasonable operating margin.

The marketing department responded that selling the new product at € 8.20 per pack was out of the question; therefore, in their opinion, only two alternatives remained:

a.Abandon the whole project.

b. Establish a consumer price of € 6.85 and a price to the retailer of € 4.78. The 8% margins and discounts to wholesalers and the 4% general overhead would then amount to 0.38 + 0.19 instead of 0.46 + 0.23, a reduction of 0.12. The production fixed expense would need to be reduced from 1.20 to 0.54, the same amount as for one standard pack of sliced beef brisket in gravy.

Despite of the marketing department's arguments, the CEO decided that the new product should not be introduced without full coverage of fixed expenses. It would be introduced at a consumer price of € 8.20, and the 1999 sales budget was set at 85 tons. This was about forty-five percent of the budgeted sales figure for the standard "Meat Pack" of sliced beef brisket in gravy, which itself reflected the assumption that the upward sales trend of recent years would continue. In other words, the company did not expect that the new "Family Pack" product would steal sales from the standard "Meat Pack". Some customers would certainly switch over from the old product to the new, but these losses would be offset by the added sales resulting from greater consumer awareness of Danish Premium products due to the planned advertising campaign for the "Family Pack."

In the months that followed, a number of complaints about the high price of the new product were received from retailers and consumers, and sales for 1999 amounted to only 30 tons in contrast to the budgeted 85 tons. Sales of the standard "Meat Pack", on the other hand, exceeded the budgeted volume by a small percentage.

ADDITIONAL INFORMATION

In addressing the case questions below assume that:

• The budgeted sales volume for standard "Meat Pack" (beef brisket with gravy) for 1999 was 189 tons.

• Budgeted production fixed expenses for the company for 1999 were € 1.51 million.

• Budgeted direct labor expenses for the company for 1999 were € 700,000.

• The cost item "Other product related fixed expenses" is made up essentially of advertising expenses. Thus the annual budget for that item must be committed at the beginning of the year for any product that will be sold that year.

• The cost item "Transportation and storage" represents an allocated share of the expenses for operating a fleet of company-owned delivery trucks and a company-owned finished goods warehouse. The company believes these expenses should be considered volume-dependent because the alternative to company ownership would be use of public freight companies and a public warehouse, both of which charge a price per kilogram of product handled.

Questions to guide your analysis (these are not necessarily exhaustive) of the key question, which is whether or not the “Family Pack” line should be developed and, if so, at what price, using the “beef brisket plus cabbage salad” product as a test:

1) Once the decision was made to introduce the "Family Pack" product and to advertise it according to the plan, what was the impact on profit in 1999 (before income taxes) of selling 30 tons at a retail price of € 8.20?

2) Once the decision had been made to introduce the "Family Pack" product and to advertise it according to plan, what would have been the impact on profit in 1999 (before income taxes) if 85 tons had been sold at a retail price of € 6.85?

3) Combining questions 1 and 2, which retail price would produce more incremental profit for the firm in 1999, and how much more?

4) What sales volume would be required at a retail price of € 6.85 to give the same profit impact in 1999 (before income taxes) as selling 30 tons at a retail price of € 8.20?

5) What is the total unit cost and per unit profit for 1 Kg of "Family Pack" at a retail selling price of € 6.85 and with an allocation of € 1.20 for production fixed expenses?

1. How much production fixed expense should be allocated to l Kg of "Family Pack"? Give a specific number and your logic to support the number.

7) What is your recommendation to management regarding the new "Family Pack" product for 2000?

Danish Premium Ltd.

Exhibit 1

Finance Department Proposal

(All amounts in €s)

Pack Pack Difference

Consumer Price (including VAT) 8.20 4.85 3.35

Value Added Tax (12.5% of consumer price before tax) 0.91 0.54 0.37

Consumer Price before tax 7.29 4.31 2.98

Retailer's Margin (27.5% of price to retailer) 1.57 0.93 0.64

UNIT PRICE to Retailer 5.72 3.38 2.34

Material: Beef brisket 1.67 1.67

Labor: Beef brisket preparation and cooking 0.25 0.25

Material: Cabbage and condiments 0.50 0.50

Labor: Cabbage preparation 0.25 0.25

Packaging 0.26 0.11 0.15

Transportation & Storage 0.20 0.09 0.11

Margins & Discounts to Wholesalers (8% of price to retailer) 0.46 0.27 0.19

Sundry other variable costs 0.10 0.04 0.06

Total Variable Costs 3.69 2.43 1.26

Production Fixed Expenses (€ 1.20 per kilogram) 1.20 0.54 0.66

Other Product Related Expenses 0.30 0.14 0.16

General, Selling & Admin Expenses and Overhead

(4% of price to retailer) 0.23 0.14 0.09

TOTAL UNIT COST 5.42 3.25 2.17

MARGIN PER UNIT 0.30 0.13 0.17

Danish Premium Ltd.

Exhibit 2

Marketing Department Proposal

(All amounts in €s)

Pack Pack Difference

Consumer Price (including VAT) 6.85 4.85 2.00

Value Added Tax (12.5% of consumer price before tax) 0.76 0.54 0.22

Consumer Price before tax 6.09 4.31 1.78

Retailer's Margin (27.5% of price to retailer) 1.31 0.93 0.38

UNIT PRICE to Retailer 4.78 3.38 1.40

Material: Beef brisket 1.67 1.67

Labor: Beef brisket preparation and cooking 0.25 0.25

Material: Cabbage and condiments 0.50 0.50

Labor: Cabbage preparation 0.25 0.25

Packaging 0.26 0.11 0.15

Transportation & Storage 0.20 0.09 0.11

Margins & Discounts to Wholesalers (8% of price to retailer) 0.38 0.27 0.11

Sundry other variable costs 0.10 0.04 0.06

Total Variable Costs 3.61 2.43 1.18

Production Fixed Expenses (€ 1.20 per kilogram) 0.54 0.54

Other Product Related Expenses 0.30 0.14 0.16

General, Selling & Admin Expenses and Overhead

(4% of price to retailer) 0.19 0.14 0.05

TOTAL UNIT COST 4.64 3.25 1.39

MARGIN PER UNIT 0.14 0.13 0.01