Question

Part A

Tank Corporation manufactures and sells 300,000 electrical meters using a capacity of 110,000 machine hours, enough to make 330,000 units each year, which usually includes 30,000 units that have to be reworked. Contribution margin –CM - per saleable unit is $8. Additional costs per reworked unit are:

      $7

Company engineers have devised a new process that would completely eliminate defects and therefore avoid the need for rework, and would actually increase capacity, however, this will add $315,000 in fixed manufacturing overhead each year.

Required:

1.      Determine the impact of the new process if Tank were to produce the same quantity of units as in the past. Clearly show any cost savings and extra costs.

Part B     

       Assume that Tank has proceeded with the anticipated changes, and is exploring new markets as a result of the engineering changes referred to above aswell as the increase in capacity, and has accepted a proposal to make 20,000 units of a modified version of the meter which will generate $10 of contribution margin per unit.

Required:

2.      Should Tank go ahead with this new job? Explain with proof.

3.      What other nonfinancial and qualitative factors should be considered in making this decision?

Answer 1

Part A - Q.1.

Savings in rework cost	(30000 * 7)	210000
Less: Additional Fixed Overhead		315000
Savings in costs after new process		-105000

Since, the savings are negative, we won't suggest for making the changes for $315000 additional fixed cost.

Part B - Q.2.

Defect Rate = 30000 / 300000 = 10%

Savings in rework costs	30000 * 7	210000
Additional Contribution from modified meters	20000 * 10	200000
Less: Additional Fixed Costs on applying new process		315000
Net Profit from new process		95000

Conclusion: Since, there is a net profit of $95000 from new process after considering new order, therefore, the new order should be accepted.

Q.3. Other non-financial and qualitative factors to be considered in making this decision

a) Labour demand: Whether we have sufficient labour for the additional orders. If not, whether we need to pay overtie or hire new labours.

b) Future orders: Whether this is a short term order or long term orders will follow.

c) Quality: Whether it can produce the modified product with adequate quality. Delivering poor quality products might upset customers and also damage goodwill of the firm.