Question

Exercise 2

Silven Industries, which manufactures and sells a highly successful line of summer lotions and insect repellents, has decided to diversify in order to stabilize sales throughout the year. A natural area for the company to consider is the production of winter lotions and creams to prevent dry and chapped skin.

After considerable research, a winter products line has been developed. However, Silven’s president has decided to introduce only one of the new products for this coming winter. If the product is a success, further expansion in future years will be initiated.

The product selected (called Chap-Off) is a lip balm that will be sold in a lipstick-type tube. The product will be sold to wholesalers in boxes of 16 tubes for $6.60 per box. Because of excess capacity, no additional fixed manufacturing overhead costs will be incurred to produce the product. However, a $120,000 charge for fixed manufacturing overhead will be absorbed by the product under the company’s absorption costing system.

Using the estimated sales and production of 100,000 boxes of Chap-Off, the Accounting Department has developed the following cost per box:

Direct materials$2.80

Direct labor $1.00

Manufacturing overhead $1.60

Total cost $5.40

The costs above include costs for producing both the lip balm and the tube that contains it. As an alternative to making the tubes, Silven has approached a supplier to discuss the possibility of purchasing the tubes for Chap-Off. The purchase price of the empty tubes from the supplier would be $0.80 per box of 16 tubes. If Silven Industries accepts the purchase proposal, direct labor and variable manufacturing overhead costs per box of Chap-Off would be reduced by 10% and direct materials costs would be reduced by 20%.

2. What would be the maximum purchase price acceptable to Silven Industries? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

1. Maximum purchase price = ________________per box

     

3. Instead of sales of 100,000 boxes, revised estimates show a sales volume of 126,000 boxes. At this new volume, additional equipment must be acquired to manufacture the tubes at an annual rental of $26,000. Assume that the outside supplier will not accept an order for less than 126,000 boxes.

a. Calculate the total relevant cost of making 126,000 boxes and total relevant cost of buying 126,000 boxes. (Do not round intermediate calculations.)

1. Total cost: Making_________ Buying_________

b. Based on the above calculations, should Silven Industries make or buy the boxes?

4. Refer to the data in (3) above. Assume that the outside supplier will accept an order of any size for the tubes at $0.80 per box. Which of these is the best alternative?

make all 126,000 boxes

buy all 126,000 boxes

make 100,000 boxes and buy 26,000 boxes

make 26,000 boxes and buy 26,000

Answer 1

1. The $120,000 in fixed overhead costs charged to the new product is a common cost that will be the same whether the tubes are produced internally or purchased from the outside. Hence, they are not relevant. The variable manufacturing overhead per box of Chap-Off would be

$0.40, as shown below:

Total manufacturing overhead cost per box of Chap-Off ... $1.60 Less fixed portion ($120,000 ÷ 100,000 boxes).................                                        1.20 Variable overhead cost per box.......................................                            $0.40

The total variable costs of producing one box of Chap-Off would be:

Direct   materials.............................................................	$2.80
Direct   labor...................................................................	1.00
Variable manufacturing overhead ...................................	0.40
Total variable cost per box .............................................	$4.20

If the tubes for the Chap-Off are purchased from the outside supplier, then the variable cost per box of Chap-Off would be:

Direct materials ($2.80 × 80%)......................................	$2.24
Direct labor ($1.00 × 90%)............................................	0.90
Variable manufacturing overhead ($0.40 × 90%).............	0.36
Cost of tube from outside ..............................................	0.80
Total variable cost per box .............................................	$4.30

Therefore, the company should reject the outside supplier’s offer. A savings of $0.10 per box of Chap-Off will be realized by producing the tubes internally.

2. The maximum purchase price would be $0.70 per box. The company would not be willing to pay more than this amount, since the $0.70 represents the cost of producing one box of tubes internally, as shown in Part 1. To make purchasing the tubes attractive, however, the purchase price should be less than $0.70 per box.

3. At a volume of 126,000 boxes, the company should buy the tubes. The computations are:

Cost of making 126,000 boxes:

126,000 boxes × $0.70 per box .....................	$ 88,200
Rental cost of equipment...............................	26,000
Total cost........................................................	$114,200

Cost of buying 126,000 boxes:

126,000 boxes × $0.80 per box ..................... $100,800

Or, on a total cost basis, the computations are:

Cost of making 126,000 boxes:

126,000 boxes × $4.20 per box .....................	$529,200
Rental cost of equipment...............................	26,000
Total cost........................................................	$555,200

Cost of buying 126,000 boxes:

126,000 boxes × $4.30 per box ..................... $541,800

Thus, buying the boxes will save the company $13,400 per year.

4. Under these circumstances, the company should make the 100,000 boxes of tubes and purchase the remaining 26,000 boxes from the out- side supplier. The costs would:

Cost of making: 100,000 boxes × $0.70 per box.......	$ 70,000
Cost of buying: 26,000 boxes × $0.80 per box .........	20,800
Total   cost...............................................................	$ 90,800

Or, on a total cost basis, the computation would be:

Cost of making: 100,000 boxes × $4.20 per box.......	$420,000
Cost of buying: 26,000 boxes × $4.30 per box .........	111,800
Total   cost...............................................................	$531,800

Since the amount of cost under this alternative is $10,000 less than the best alternative in Part 3, the company should make as many tubes as possible with the current equipment and buy the remaining tubes from the outside supplier.