Lynch’s Chicken Ranch, Inc.

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John Lynch, owner and president of Lynch’s Chicken Ranch, was not looking forward to the staff meeting
to be held at 1:00. He knew that Gary Dawson, manager of the Egg Division, wanted again to raise the
issue of sharing costs across divisions. Because of a 20 percent increase in the cost of chicken feed,
Gary’s division was now showing losses and, consequently, Gary and his employees would not be
earning a bonus this year.

Still, John was not convinced that Gary’s idea for having the others divisions share his problem were in
the best interest of the company.

COMPANY OPERATION S AND ECONOMICS

Lynch’s Chicken Ranch, Inc., located outside Modesto, California, was a privately owned, vertically
integrated agricultural producer. The company was organized into three divisions: Eggs, Feed and
Fertilizer. The Egg Division, managed by Gary Dawson, ran a 250,000 bird chicken coop from which it
received an average of 15,000 dozen eggs per day. These eggs were washed, graded, packaged, and sold
for a price that typically ranged between 60₵ and 80₵ per dozen, depending on the size of the eggs and
market conditions. The Egg Division bought 20-week-old laying hens from outside suppliers for $3.50-
$4.50 each. When the hens’ productivity declined and it was no longer economical to keep them,
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typically 1-1 years later, they were sold to food processors, particularly soup makers, for 12₵ per
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pound (approximately 50₵ per hen).

In total, the chicken flock consumed between 28 and 75 tons of corn and soybeans per day. The Feed
Division, managed by Ron Johnson, grew this grain and sold it to the Egg Division at market prices. A by-
product of the feed operation was corn mulch, which was made from dried and mulched corn plants and
cobs. This mulch was sold to the Fertilizer Division for $30 per ton. The price just covered the Feed
Division’s incremental cost of preparing the mulch, but Ron was happy to have this break-even business
because he used to have to pay to have the plants and cobs hauled away.

Each chicken produced an average of quarter pound of droppings per day. In the past, disposal of the
great quantity of manure produced by large flock had cost as much as $250,000 per year. But disposal
had recently become much easier because of the development of the Brill digester, a device that
converted the manure into an odorless substance that could be used either for fertilizer or cattle feed.
Converted chicken dropping were valuable because they contained many nutrients including, for
example, mere protein than alfalfa. In 1988, John Lynch formed a new Fertilizer Division to capitalize on
this new business opportunity and hired Judy Smith to manage it.

Employees of the Egg Division cleaned the chicken coop and loaded the manure into a special bin, the
contents of which were then dumped into one of the seven Brill digesters the ranch owned. The digester
converted the manure into dry, odorless flakes. Each digester cost $40,000 and was able to handle 10
tons of manure every two days. Judy explained the conversation process further:

Our digesters are designed with two containers, each about seven feet wide and four feet deep. We load the first
with chicken droppings and an equal portion of corn mulch. Large paddle wheels, driven by an electric motor,
rotate the mixture slowly, and heating elements warm it to between 150 and 170 degrees. The heat evaporates
most of the moisture and eliminates the unpleasantness. The second container is used to spin the materials to dry
it completely. The whole process takes 48 hours.

The finished product was then either bagged as fertilizers, to be marketed under the Lynch’s Pride brand
name, or as cattle feed supplement. Prices fluctuated significantly, so the division bagged whatever
product had the higher margin at the time. The demand for both products outstripped capacity, so the
division had to hold little or no finished goods inventory.

THE STAFF METTING

The main issue for discussion at the February staff meeting was a conflict that had arisen because of
increase in the cost of chicken feed. The issue was provoking heated discussion because it had directly
effects on division managers bonuses. The division managers’ base salaries were set at levels slightly
below industry averages, but the managers’ total compensation packages were fully competitive
because they were given the opportunities to earn significant bonuses based on division profits.

Here is a shortened paraphrase of the discussion that took place at the staff meeting:

Gary: Well, as you are all aware, the drought in the Midwest has severely affected the market price of
corn and soybeans. Because of this and the artificial way that we keep our books, the Egg Division is
going to show a loss this year. That’s not fair. I propose that we make two changes. First, because our
corn yields were not affected by the drought, Ron should forgo the increase in the price he charges us.
Second, I don’t think it is fair that my division should pay for all the cost of manufacturing while the
Fertilizer Division gets all the profits. I think we should apportion the cost between the two divisions. As
we all know, 40 percent of the nutrients in the food goes straight through the chicken, and it’s these
nutrients that Judy is marketing. Therefore, I think she should pick up 40 percent of the cost of the food.
I think she should also pay her fair share of the cost of producing her raw materials, and those include
the depreciation of the chickens and costs of operating the coop. the same 40 percent apportioning rule
is probably as good here as any.

Judy: Gary, I am getting tired of this discussion. You’re crazy if you think I’m going to pay for your
inability to make profit. I’m already giving you $200,000 kick to your bottom-line by removing the
manure for free. By all rights, I should be charging you.

Ron: Gary, if you don’t want to pay market price for my grain, that’s fine. If you don’t want it, someone
else will buy it. But I’m not going to let you stick me with your problem. In the year before last, when
there was a bumper crop and grain prices were depressed, I don’t remember you offering to pay me a
bonus then.
Gary: If I’ve got to go this alone, I’m going to cut my losses. Right now I’m losing about 6₵ on every flat
of eggs I sell. Olsen Farms’ managers want to expand their flock, and they are willing to pay me $1.75 for
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my 1 -2-year-old layers. That’s an average of 25₵ each over book value for the 100,000 layers in this
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group. I’ll sell those layers and reduce my labor cost by laying off my third shift and half of my second
shift. With these cuts, I should be able to at least break even. Next year if prices are more reasonable, I’ll
rebuild the flock.

Ron: I have no problem with that.

Judy: Wait a minute. You can’t do that. If you cut the flock by 40 percent, I won’t have the volume I need
to cover my fixed costs. You can’t just think of your own self; you’ve got to think of the company as a
whole. Right J.L.?

John: I don’t know right now. Let me get Ricardo [Lynch’s controller] to do an analysis of the options.
Let’s discuss this again next week.

Question
What should John Lynch do?