Question

Jake Chemicals – Short-Term Decision Making

“If these new products are to be competitively priced, we have got to do something about

our container costs” said Mr. Walsh. Walsh is the general manager of Jake Chemicals

which manufactured and sold a range of high-grade chemical products. These products

required careful packing and the company made a special feature of the properties of the

containers used. They used patented lining made from a material known as GHL, and the

firm operated a department especially to maintain its containers in good condition and to

make new ones to replace those that were past repair.

“I believe that we can achieve substantial economies if we buy our containers from an

outside source” continued Walsh. “I have been making some inquiries and it appears that

Packages would offer us a contract, for five years certain, to keep our containers in good

repair and to make all the containers we are planning to need. This would cost £500,000

per year and I believe they would offer us as good a service as we could get elsewhere, or

by doing the job ourselves. The equivalent cost of doing it ourselves is £578,000 per year

so that over a five year period we would save nearly £400,000 if we make the change

now.”

The £578,000, which Walsh quoted was made as follows:

£

Materials 200,000

Labour 145,000

Manager’s salary 34,000

Rent 45,000

Depreciation of machinery 33,500

Maintenance of machinery 10,500

Other expenses 42,500

510,500

Proportion of general administrative overheads 67,500

578,000

Mr. Duffy, the manager of the containers department, looked thoughtful and asked for

time to think the matter over. The next morning he asked to speak to Walsh again, and

said he thought there were a number of points that ought to be borne in mind before his

department was closed. “For instance”, he said, “we would have to scrap the machine. It

cost us £360,000 three years ago, but there isn’t a market for second-hand equipment of

this type and you’d be lucky if you got £50,000 for it now, even though it’s good for

another five years. And then there’s the inventory of GHL (the special chemical) we

bought a year ago. That cost us £150,000. We used up about third of it last year. The

material cost you quoted yesterday (£200,000) probably includes about £50,000 for GHL.

We bought it for £1,500 a ton, and you couldn’t buy it today for less than £1,800, but it is

tricky stuff to handle and if you sold it you wouldn’t have more than £1,200 a ton left after

handling expenses have been allowed for.”

Walsh admitted that Duffy had raised a number of points that ought to be borne in mind.

He also pointed out that Duffy need have no fear of redundancy because, if his department

were closed, he would be moved to another managerial post which was shortly becoming

vacant, without loss of pay or prospects.

Duffy seemed relieved to hear this, but said that he was worried about the workers in his

department. “Perhaps you could see if Packages would take some of them on”, he said

“but otherwise I am afraid I cannot see them fitting into any of our other sections without

considerable retraining.”

Walsh agreed and said he would see what could be done. He went on, “Of course the

closure of your department would release much needed space. At the moment we are

renting outside warehouse space which is costing us £45,000 a year. The closure of your

department would mean we would have all the additional space we need without outside

renting.”

“Do you think there would be any saving in general administrative overheads?” asked

Duffy. “As you know, I am being charged £67,500 a year for this service from Head Office.”

“Probably not” said Walsh, “but remember that someone will still have to pay for these

costs and we can ignore them in our calculations. Well, I think we have thrashed this out

pretty fully. This has been a useful discussion. I will let you know what I decide by the

end of the week.”

Questions

1. From the information given in the case, if Walsh signs with Packages will Jake

Chemicals be better off or worse off financially?

Answer 1

Total Cost of Material=$50,000

Cost per tonne-$1,500

Total Material purchased (in tonnes)=33.33 tonnes

Material used in first year=1/3rd=11.11 tonnes

Material Left=22.22 tonnes

Net Benefit if offer is accepted

Amount received from the sale of second hand equipment = 50,000

Amount received from the sale of materials= 26,667 (22.22 tonne*1200)

Savings in Material Cost=150,000

Savings in Warehouse Cost=45,000

Savings in Depreciation Cost=33,500

Savings in Labour Cost=145,000

Savings in Other Expenses=42,500

Savings in Manager Salary=34,000

Savings in Maintenance Charges of Machinery=10,500

Total Savings=5,37,167

-) Cost of Packages Contract= (500,000)

-) Loss of usage of depreciation for further 5 years (360,000/8*5)= (2,25,000)

-) Purchase Cost of Material(1500*22.22 tonnes)=(33,330)

Total Cost=7,58,330

Net Payable=758,330-5,37,167=221,163

Hence, it is not beneficial to accept the contract

Note No. 1- It is to be remember that proportion of General Administrative Overhead is required to be paid whether or not we accepts the offer or not. So it would not be considered as relevant cost for the purpose of Decision Making.

Note No. 2- It is not clearly mention in the question that what is the written down value of the machinery. But one such thing has been mentioned that the machinery is good for further 5 years. So in the absence of requisite information, machinery useful life is expected to be of 8 years.

Note No. 3 - The above mentioned answer may differ, on the basis of assumption of the useful life of machinery.