Question

Destin Company produces water control valves, made of brass, which it sells primarily to builders for use in commercial real estate construction. These valves must meet rigid specifications (i.e., the quality tolerance is small). Valves that, upon inspection, get rejected are returned to the Casting Department; that is, they are returned to stage 1 of the four-stage manufacturing process. Rejected items are melted and then recast. As such, no new materials in Casting are required to rework these items. However, new materials must be added in the Finishing Department for all reworked valves. As the cost accountant for the company, you have prepared the following cost data regarding the production of a typical valve:

Cost	Casting				Finishing				Inspection				Packing				Total
Direct materials	$	150			$	13			$	0			$	7			$	170
Direct labor		90				100				40				40				270
Variable manufacturing overhead		80				130				40				40				290
Allocated fixed overhead		50				60				85				55				250
	$	370			$	303			$	165			$	142			$	980

The company, spurred by intense price pressures from foreign manufacturers, recently initiated a number of quality programs. As a result, the rejection rate for valves has decreased from 5.9% to 4.6% of annual output (equal in total to 15,000 units). The reduction in reject rates has enabled the company to reduce its inventory holdings from $490,000 to $295,000. Destin estimates that the annual financing cost associated with inventory holdings is 12%.

Required:

1. What are the estimated manufacturing cost savings per year associated with the reduction in rework costs?

2. What is the annual financing cost savings associated with the reduction in inventory holdings?

3. Provide a dollar estimate of the total annual cost savings associated with the recently enacted quality improvements.

(Do not round intermediate calculations.)

Answer 1

ANSWER:

Manufacturing cost savings associated with the reduction in rework costs:

= (reduction in reject rate) x (annual volume of output) x (total rework cost per unit)

= (0.059*0.046)*15000*((370-50-150)+(303-60)+(165-85))/unit

=20,070.03

Financing cost savings

Reduction in inventory holdings = $490,000 - $295000 = $195,000

Estimated inventory carry cost per annum                     = x 0.12

Estimated annual savings                                                   = $23,400

Total estimated savings due to quality improvement program

= rework cost savings + inventory financing cost savings

= $20,070.03 + $23,400 = $43,470.03