Question

Plant Closing Decision

QualSupport Corporation manufactures seats for automobiles, vans, trucks, and various recreational vehicles. The company has a number of plants around the world, including the Denver Cover Plant, which makes seat covers.

Ted Vosilo is the plant manager of the Denver Cover Plant but also serves as the regional production manager for the company. His budget as the regional manager is charged to the Denver Cover Plant.

Vosilo has just heard that QualSupport has received a bid from an outside vendor to supply the equivalent of the entire annual output of the Denver Cover Plant for $35 million. Vosilo was astonished at the low outside bid because the budget for the Denver Cover Plant’s operating costs for the upcoming year was set at $52 million. If this bid is accepted, the Denver Cover Plant will be closed down.

The budget for Denver Cover’s operating costs for the coming year is presented below.

Additional facts regarding the plant’s operations are as follows:

a. Due to Denver Cover’s commitment to use high-quality fabrics in all of its products the Purchasing Department was instructed to place blanket purchase orders with major suppliers to ensure the receipt of sufficient materials for the coming year. If these orders are canceled as a consequence of the plant closing, termination charges would amount to 20% of the cost of direct materials.

b. Approximately 400 plant employees will lose their jobs if the plant is closed. This includes all of the direct laborers and supervisors as well as the plumbers, electricians, and other skilled workers classified as indirect plant workers. Some would be able to find new jobs while many others would have difficulty. All employees would have difficulty matching Denver Cover’s base pay of $18.80 per hour, which is the highest in the area. A clause in Denver Cover’s contract with the union may help some employees; the company must provide employment assistance to its former employees for 12 months after a plant closing. The estimated cost to administer this service would be $1.5 million for the year.

c. Some employees would probably choose early retirement because QualSupport has an excellent pension plan. In fact, $3 million of the annual pension expense would continue whether Denver Cover is open or not.

d. Vosilo and his staff would not be affected by the closing of Denver Cover. They would still be responsible for administering three other area plants.

e. If the Denver Cover Plant were closed, the company would realize about $3.2 million salvage value for the equipment and building. If the plant remains open, there are no plans to make any significant investments in new equipment or buildings. The old equipment is adequate and should last indefinitely.

Required:

1. Without regard to costs, identify the advantages to QualSupport Corporation of continuing to obtain covers from its own Denver Cover Plant.

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2. QualSupport Corporation plans to prepare a financial analysis that will be used in deciding whether or not to close the Denver Cover Plant. Management has asked you to identify:

a. The annual budgeted costs that are relevant to the decision regarding closing the plant (show the dollar amounts).

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b. The annual budgeted costs that are irrelevant to the decision regarding closing the plant and explain why they are irrelevant (again show the dollar amounts).

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c. Any nonrecurring costs that would arise due to the closing of the plant, and explain how they would affect the decision (again show any dollar amounts).

3. Looking at the data you have prepared in (2) above, what is the financial advantage (disadvantage) of closing the plant? Show computations and explain your answer.

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4. Identity any revenues of costs not specifically mentioned in the problem that QualSupport should consider before making a decision.

Answer 1

Decision for closing a plant:

Decision is taken carefully to determine whether the particular product line or segment of the company must be dropped or additional one must be added according to the requirements of relevant cost and the avoidable cost.

1.

The advantages of Q Corporation to continue from its own plant are as follows:

• It allows Q Corporation to maintain its current level of control over the quality of the covers and timing involved in their delivery.

• The plant allows Q to support with more flexibility than purchasing the covering from the outside suppliers.

• In the long contract Q supports can be easily change the covering design and quantities produced with the required outside suppliers.

• Q supports must be aware of the economic impact on the closing cover plant which has on the community and its affects to the operation in the region.

2.

a)

Computation of total annual relevant cost to avoid unnecessary cost by closing plant:

It is given that the total material is $14,000,000; direct is $13,100,000; supervision is $9,000,000; indirect plant is $4,000,000; pension expenses is $5,000,000 and annual pension expense is $3,000,000.

From the above data compute differential pension cost:

Hence, the differential pension cost is

Particulars	Amount	Amount
Material		$14,000,000
Labor:
Direct	$13,100,000
Supervision	$9,00,000
Indirect plant	$4,000,000
Total labors		$18,000,000
Add: Differential pension cost		$2,000,000
Total annual relevant cost		$34,000,000

From the above calculation it is clear that the total annual relevant cost of is an unnecessary cost incurred.

b)

Computation of total annual continuing cost to avoid unnecessary cost by closing plant:

It is given that the depreciation on equipment is $3,200,000; depreciation on building is $7,000,000; plant manager and staff is $800,000; corporate expense is $4,000,000; pension expenses is $5,000,000, and from the above calculation differential pension cost is $2,000,000.

From the above data compute continuing pension cost:

From the above calculation it is clear that the total annual are not relevant cost is is the unnecessary cost incurred.

Particulars	Amount
Depreciation on equipment	$3,200,000
Depreciation on building	$7,000,000
Continuing pension cost	$3,000,000
Plant manager and staff	$800,000
Corporate expenses	$4,000,000
Total annual continuing cost	$18,000,000

Therefore, the total annual continuing cost is

c)

Computation of nonrecurring costs which arise in the year that the plant is closed which has not done in another year:

It is given that the material incurred is $14,000,000, the termination charge is 20% on direct material, and the estimated cost on employment assistance is $1,500,000.

From the above data compute termination charge on canceled material order:

From the above calculation it is clear that the termination charge on cancelled material order is.

Particulars	Amount
Termination charges on canceled material order	$2,800,000
Employment assistance	$1,500,000
Total recurring cost	$4,300,000

Therefore, the total annual continuing cost is

3.

Computation to determine why the plant should be closed:

It is that the cost of purchasing the covers outside is $35,000,000 for the first year and for other successive years; from the above it is already computed total annual relevant cost is $34,000,000 for the first year and for other successive years; the total annual continuing cost is $4,300,000 and the salvage value of equipment and building is $3,200,000

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Therefore, it is clear from the above calculation the net advantage of closing the plant of first year amount is $(2,100,000) and other year amount is $(1,000,000). So it is clear now that plant should not be closed.

4.

Factors that must be determined by Q support before making decision are as follows:

• Different use of building and equipments must be taken into account before making decision.

• Certain tax implications must be also considered for making proper plans.

• Pricing variation that must be taken place in the future must be also determined for better strategic plan.

• Cost incurred for manufacturing covers on the plants.

• Principles and morale of support employees at outstanding plants.

• Time management must also be taken into account for making decisions.