Question

 

Roll and Wind Cable, Inc. (“R&W”) manufactures 15,000 rolls of cable each period. The cable is used as an input for producing several other products that R&W manufactures. For a 100-roll batch, R&W’s manufacturing costs are:

Direct materials	$125
Direct labor	85
Manufacturing overhead	400
Total	$610

Included in manufacturing overhead is $215 per batch related to annual depreciation expenses and insurance cost on production facilities and production equipment. No other costs or expenses need to be considered.

An outside supplier has offered to sell R&W the 15,000 rolls of cable necessary to meet production needs this period for a lump-sum of $65,000. If R&W accepts the outside supplier’s bid, they will have excess production capacity that can be used to generate $12,000 of additional income.

Assume that using the outside supplies will not impact the company’s sales activities.

Required

1. 1. Using the given information, evaluate and provide advice to the company regarding accepting or rejecting the outside supplier’s offer. Assume that, if they decide to accept the outside vendor’s offer, Roll & Wind will have to divert the time of one of their existing employees to manage the supply chain associated with using the outside vendor. Currently, that employee is paid $50,000.
2. Using the same information, re-evaluate the outside suppliers offer, with the additional facts:
   1. R&W is not able to generate additional from their excess production capacity and
   2. They will incur additional costs and income associated with the shut-down/removal of the excess capacity:
      1. $15,000 of cost related to retiring and removing production equipment,
      2. The retired equipment will generate about $5,000 of income as salvage, and
      3. $2,500 of expenses related to cleaning and refurbishing the cleared production space.

My solution:

We ignore fixed cost, i.e. $250 of manufacturing overhead related to annual depreciation expenses and insurance cost on production facilities and production equipment while comparing. This is Sunk Cost or Non-relevant cost while making decision.

Relevant cost to make 100 rolls:

Direct materials (15,000/100) x 125	$18,750
Direct labor (15,000/100) x 85	12,750
Manufacturing overhead 150 x 185	27,750
Total	$59,250

Cost of 15,000 rolls if purchased from outside = $65,000

So for maximize the profit Roll and Wind Cable, Inc. should produce cable than purchasing from outside supplier as it will decrease its cost thereby increase is profits by $65,000 - $ 59,250 = $ 5,750 per period.

2. Total cost would be $71,750

I'm not sure if in question two these expenses could be considered as sink cost.

Also, in question, one manager's salary confuses me. Is it sink cost or not?

Thank you!

Answer 1

In part 1 of the question, your $59,250 cost of production is correct but you did not consider $12,000 additional income if R&W accepts outside supplier offer. So this is an opportunity gain which will only be generate, if R&W accepts outside supplier offer.

So the net cost of outside supplier offer would be $53,000 (i.e. $65,000 - $12,000) which is lower than inhouse cost of production $59,250.

Decision for part 1 of the question: R&W should accept the outsider supplier offer.

In regards to your query about manager salary $50,000, this is an overhead that cannot be avoided & whether we produce or outsource the rolls this would be incurred in both case, hence the decision of production or outsource is not affected by this irrelevant cost.

Further part 2 of the question, there is no additional income generated & total cost of outsider supplier offer would be:

Cost of outsider supplier offer = $65,000

Add: Relevant Cost: Cost of retiring and removing production equipment = $15,000

Less: Opportunity Gain: Salvage Income = ($5,000)

Add: Relevant Cost: Cost of expenses related to cleaning and refurbishing = $2,500

Total Cost = $77,500

Now cost of production of roll $59,250, is cheaper than all relevant costs in outsource supplier offer $77,500.

Decision for part 2 of the question: R&W should produce the rolls.

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