Question

1. Sam's Shampoo, Inc. currently bottles its own shampoo. Management is interested in outsourcing the production of bottles to a reputable manufacturing company that can supply the bottles for $0.04 each. Sam's Shampoo, Inc. incurs the following monthly production costs to produce 1,000,000 bottles internally.

	Cost per unit	Total monthly cost at 1,000,000 units
Variable production cost	$0.02	$20,000
Fixed production cost		$25,000
Total production cost		$45,000

If production is outsourced, all variable production costs and 70 percent of fixed production costs will be eliminated.

1. Perform differential analysis for the outsourcing decision.

2. Which alternative is best? Explain.

3. Assume all the facts of this problem remain the same. However, management of Sam's Shampoo has an opportunity to lease the space it currently uses to produce bottles for $6,000 per month if production of bottles is outsourced to determine if Sam's Shampoo would be better off outsourcing production. (Hint: $6,000 will appear in the analysis as an opportunity cost.)

4. Identify at least one qualitative factor that should be considered before management decides to outsource production.

Answer 1

a)

Differnetial Analysis Cash fllow: Cost incurred to buy (1,000,000 $0.04) ($40,000) Inflows: Cost saved Variable cost (1,000,000 x $0.02) Fixed cost ($25,000 x 70%) $20,000 $17,500 Net (outflow) Inflow ($2,500)

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b)

Outsourcing decision will increase cost of the compnay by $2,500. hence make decision will continue apply.

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c)

If space leased for $6,000 per month, compute analysis as follows:

Differnetial Analysis Cash fllow: Cost incurred to buy (1,000,000 $0.04) (S40,000) Inflows: Cost saved Opportunity cost Variable cost (1,000,000 x $0.02) Fixed cost ($25,000 x 70%) $6,000 $20,000 $17,500 Net (outflow)/Inflow $3,500

In this situation company saved $3,500. hence accept the decision of outsource.