Question

Problem 12-23 Make or Buy Decision [LO12-3]

Silven Industries, which manufactures and sells a highly successful line of summer lotions and insect repellents, has decided to diversify in order to stabilize sales throughout the year. A natural area for the company to consider is the production of winter lotions and creams to prevent dry and chapped skin.

After considerable research, a winter products line has been developed. However, Silven’s president has decided to introduce only one of the new products for this coming winter. If the product is a success, further expansion in future years will be initiated.

The product selected (called Chap-Off) is a lip balm that will be sold in a lipstick-type tube. The product will be sold to wholesalers in boxes of 24 tubes for $9 per box. Because of excess capacity, no additional fixed manufacturing overhead costs will be incurred to produce the product. However, a $105,000 charge for fixed manufacturing overhead will be absorbed by the product under the company’s absorption costing system.

Using the estimated sales and production of 150,000 boxes of Chap-Off, the Accounting Department has developed the following manufacturing cost per box:

Direct material	$	4.10
Direct labor		2.40
Manufacturing overhead		1.80
Total cost	$	8.30

The costs above relate to making both the lip balm and the tube that contains it. As an alternative to making the tubes for Chap-Off, Silven has approached a supplier to discuss the possibility of buying the tubes. The purchase price of the supplier's empty tubes would be $1.70 per box of 24 tubes. If Silven Industries stops making the tubes and buys them from the outside supplier, its direct labor and variable manufacturing overhead costs per box of Chap-Off would be reduced by 10% and its direct materials costs would be reduced by 30%.

Required:

1. If Silven buys its tubes from the outside supplier, how much of its own Chap-Off manufacturing costs per box will it be able to avoid? (Hint: You need to separate the manufacturing overhead of $1.80 per box that is shown above into its variable and fixed components to derive the correct answer.)

2. What is the financial advantage (disadvantage) per box of Chap-Off if Silven buys its tubes from the outside supplier?

3. What is the financial advantage (disadvantage) in total (not per box) if Silven buys 150,000 boxes of tubes from the outside supplier?

4. Should Silven Industries make or buy the tubes?

5. What is the maximum price that Silven should be willing to pay the outside supplier for a box of 24 tubes?

6. Instead of sales of 150,000 boxes of tubes, revised estimates show a sales volume of 185,000 boxes of tubes. At this higher sales volume, Silven would need to rent extra equipment at a cost of $65,000 per year to make the additional 35,000 boxes of tubes. Assuming that the outside supplier will not accept an order for less than 185,000 boxes of tubes, what is the financial advantage (disadvantage) in total (not per box) if Silven buys 185,000 boxes of tubes from the outside supplier? Given this new information, should Silven Industries make or buy the tubes?

7. Refer to the data in (6) above. Assume that the outside supplier will accept an order of any size for the tubes at a price of $1.70 per box. How many boxes of tubes should Silven make? How many boxes of tubes should it buy from the outside supplier?

Answer 1

Solution 1:

Total manufacturing overhead per unit at 150000 boxes = $1.80 per unit

Fixed manufacturing overhead per unit = $105,000 / 150000 = $0.70 per unit

Variable manufacturing overhead per unit = $1.80 - $0.70 = $1.10 per unit

Reduction in Chap-Off manufacturing costs per box, if tubes purchased from outside vendor = (Direct labor cost per unit + Variable manufacturing overhead per unit) * 10% + Direct material cost per unit * 30%

= ($2.40 + $1.10)*10% + ($4.10*30%) = $1.58 per unit

Solution 2:

financial advantage (disadvantage) per box of Chap-Off if Silven buys its tubes from the outside supplier = $1.58 - $1.70 = ($0.12)

Solution 3:

Financial advantage (disadvantage) in total (not per box) if Silven buys 150,000 boxes of tubes from the outside supplier = -$0.12 * 150000 = ($18,000)

Solution 4:

As there is net financial disadvantage of $18,000, therefore silven should make the tubes.

Solution 5:

Maximum price that Silven should be willing to pay the outside supplier for a box of 24 tubes is equal to its variable cost to make i.e. $1.58 per box

Solution 6:

Cost to make 185000 boxes = 185000*$1.58 + $65,000 = $357,300

Cost to buy 185000 boxes = 185000 * $1.70 = $314,500

Net financial advantage (disadvantage) of buying = $357,300 - $314,500 = $42,800

Therefore silven industries should buy the tubes.

Solution 7:

If outside supplier will accept an order of any size for the tubes then silven industries should make 150000 tubes and buy 35000 boxes of tubes from outside supplier.