Question

Mr. Sauron’s company in Dol Guldur manufactures a variety of ballpoint pens. The company has just received an offer from an outside supplier to provide the ink cartridge for the company’s Nenya pen line, at a price of $0.48 per dozen cartridges. The company is interested in investigating whether this offer is worth pursuing. Mr. Sauron estimates that if the supplier’s offer were accepted, the variable direct labor and variable manufacturing overhead costs of the Nenya pen line would be reduced by 10% and the direct materials cost would be reduced by 20%. Under present operations, Mr. Sauron manufactures all of its own pens from start to finish. The Nenya pens are sold through wholesalers at $5 per box. Each box contains one dozen pens. Fixed manufacturing overhead costs allocated to the Nenya pen line total $50,000 each year. (The same equipment and facilities are used to produce several pen lines.) The present cost of producing one dozen Nenya pens (one box) is given below:

Direct materials $1.50
Direct labor 1.00
Manufacturing overhead 0.80*
Total cost $3.30
*Includes both variable and fixed manufacturing overhead, based on production of 100,000 boxes of pens each year.

REQUIRED: 1. Should Mr. Sauron accept the outside supplier’s offer for the cartridges? Show computations.

2. What is the maximum price that Mr. Sauron should be willing to pay the outside supplier per dozen cartridges? Explain.

3. Assume for part 3 alone that the company has decided to revise the selling price per box of Nenya pens. The company has decided to now use a 50% markup on full production cost to determine the selling price. What will be the new selling price per box of Nenya pens?

4. Go back to the original data for the Nenya pens and ignore the issue with outsourcing and part 3 above. Assume the company is also producing Vilya pens with the following cost structure per dozen pens (BOX):

Direct Materials 0.50

Direct Labor 2.00

Manufacturing OH 0.60 (allocated based on 100,000 boxes per year)

Total cost $3.10

Fixed MOH costs allocated to the Vilya pen line also total $50,000 per year and the selling price for Vilya pens per box is also $5.00 (same as Nenya). Labor hours are a scarce resource and the company wishes to maximize the total contribution margin. Assuming that labor costs are $12/ hour and that 1920 Hours are available per year, how many labor hours should be given to the Vilya pen line and how many to Nenya? The company can choose to produce as many units of either pen as it desires. Demand for the pens is not a constraint. Please provide calculations in support of your answer.

5. How would your answer to part (4) above change, if at all, if annual demand for the Nenya pens was15000 boxes and annual demand for the Vilya pens was 6000 boxes?

Answer 1

1	The company should not accept the offer, as production of ink cartridges internally
	would be $ 0.05 cheaper than purchasing from the supplier.
	The savings in accepting supplier's offer as per Mr. Sauron estimates are:-
		Cost	% savings	savings
	Direct materials	$1.50	20%	$0.30
	Direct labor	$1.00	10%	$0.10
	Manufacturing overheads ( $: 0.8 )
	Fixed overheads ($ 50,000 / 1,00,000 units)	$0.50
	Variable overheads $ ( 0.8 - 0.5 ) = $ 0.3	$0.30	10%	$0.03
	Total Cost of production	$3.30		$0.43
	cost of purchasing ink cartridges from outside:			$0.48
	Savings per box by production of cartridges internally is			$0.05
2	The maximum price that Mr. Sauron should be willing to pay the outside
	supplier per dozen cartridges is $ : 0. 43 per box.
	Because, this is the cost incurred if cartridges are produced internally.
	So, they should not pay to outside supplier over and above the cost that would be incurred if produced internally.
3	The new selling price per box of Nenya pens woule be $ 5.03
	considering the cartridge outsourced from supplier, the added cost would be $.0.05
	(i.e., $ 0.48 - $ 0.43) = $: 0.05
	Cost of production ($.3.30 + $ 0.05)	$3.35
	profit margin (50% markup on production cost)	$1.68
	New selling price per box is	$5.03
4	Taking in consideration of scarce resource of labour, calculating maximum
	boxes that can be produced out of available 1920 hours per year
		Nenya	Vilya
	Number of boxes produced in one hour is	12	6
	Total boxes that can be produced in 1920 hours	23040	11520
	Contribution margin of both Nenya & Vilya out of available labour hours
		Boxes per year			Boxes per year
		of Nenya	23040		of Vilya	11520
	Selling price	$5.00	$115,200		$5.00	$57,600
	variable cost
	Direct Material	$1.50	$34,560		$0.50	$5,760
	Direct labour	$1.00	$23,040		$2.00	$23,040
	Variable overheads	$0.30	$6,912		$0.10	$1,152
	Total Variable cost	$2.80	$64,512		$2.60	$29,952
	Contribution margin	$2.20	$50,688		$2.40	$27,648
	As contribution margin is maximum in Nenya pens than Vilya pens,
	it is advisable to produce only Nenya pens for maximum profit
		Nenya	Vilya	TTL
5	No. of boxes in demand per annum	15000	6000
	No. of boxes produced per hour	12	6
	Total hours required for production	1250	1000	2250
	But only 1950 hours are available per year
	So, as contribution of Nenya pens is more than Vilya,
	All the 15000 boxes of Nenya pens should be produced and
	Vilya pens should be produced with the available labour hours as follows:-
	Production hours balance available is	1920
	Productin hours required for Nenya pens are	1250
	Available hours for producing Vilya pens are	670
	No. of boxes produced per hour	6
	No. of Vilya pens boxes that can be produced are	4020