Question

Horizon Insurance (HI) was a full-service regional insurance agency that has done all the printing and publishing of its own promotional brochures, newsletters, informational pamphlets, and required regulatory reports. Linda Wolfe, the business manager of the agency, had for some time thought that the firm might save money and get equally good services by contracting the publishing work G-Art Inc. She asked G-Art Inc. to give her a quote at the same time she asked Bob Myer her controller to prepare an up-to-date statement of the cost of operating Horizon’s publishing department.

Within a few days, the quote from G-Art Inc. arrived. The firm was prepared to provide all the required publications work for $ 410,000 a year with the contract running a guaranteed term of 4 years with annual renewals thereafter. If the estimated number or assumed mix of publications changed in any given year beyond the baseline planning estimates, the contract price would be adjusted accordingly. Wolfe compared G-Art’s quote with the internal cost figures prepared by Myer:

Table 1; Annual cost of operating HI’s publications department: Myer’s figures.

Materials............................................................................................$40,000

Labor.................................................................................................$290,000

Department overhead

Manager’s salary .....................................................$48,000                                  

Allocated cost of office space...................................$10,000

Depreciation of equipment........................................$32,500

Other expenses (travel, education, ect.)...................$25,000

.............................................................................................................................$115,500

.............................................................................................................................$445,500

Share of company administrative overhead.........................................................$30,000

Total cost of department for year.........................................................................$475,000

Wolfe’s initial conclusion was to close Horizon’s publications department and immediately sign the contact offered by G-Art. However, she felt it prudent to give the manager of the department, George Richards, an opportunity to question that tentative conclusion. She called him in and put the facts before him, while at the same time making it clear that Richards’ own job at the agency was not in jeopardy.

Richard came up with the following to keep in mind before his department was closed:

For instance, what will you do with the customed graphic design and printing equipment? It cost $260,000 four years ago, but you’d be lucky if you got $80,000 for it now, even though we had planned on using it for another four years at least. Andthen there is the sizable supply of print materials that includes a lot of specialized ink, specialty card stock, paper, envelopes ect. We bought the custom supplies a year ago when we were pretty flush with cash. At that time it cost us about 125,000 and at the rate we are using it now, it will last us another four years. We used up about one-fifth of it last year. As best as I an tell, Myer’s figure of $40,000 for materials includes about $25,000 for these customized sipplies and $15,000 for generic supplies we use on a regular basis. If we were to buy these custom supplies today it would probably cost us 110% of what we paid for it. But if we try to sell it, we would probably get only 60% of what we paid for it.

Wolf thought that Myer ought to be present during this discussion. She called him in and put Richard’s points to him. Myer said:

If we are going to have all of this talk about “what will happen if” don’t forget the problem of space we’re faced with. We’re paying 12,000 a year in outside office space. If we close Richard’s department we could use of the freed-up space as office space and not need to rent it on the outside.

Wolfe replied:

That’s a good point, though I must say I’m a bit worried about the people if we close the publications department. I don’t think we can find room for any of them elsewhere in the firm. I could see whether G-rt can take any of them, but some of them are getting odler. There’s Walters and Hines, for example. They’ve been with us since they left school 40 years ago, and I think their contract requires us to give them a total severance payoff of about $60,000 each, payable in equal amounts over four years.

Richards showed some relief at this. “ But I still don’t like Myer’s figures” he said. “What about the $30,000 for general administrative overhead. You surely don’t expect to fire anyone in the corporate office if Im closed, do you?

“Probably not” said Myer, but someone has to pay for those costs. We can’t ignore them when we look at an individual department, because fi we do that with each department in turn, we will convince ourselves that accountants, laywers, vice presidents, and the like don’t’ have to be paid for. And they do, believe me”

"Well, I think we've thrashed this out pretty fully," said Wolfe. I've told G-Art that i'd let them know my decision within a week. I'll let you know what I decided to do before I write to them."

What would be the problem with taking G-Art's contract?

Answer 1

1. Internal costing of the project as Project A

2. G-Art Inc Quotation as Project B

Internal- Project A costs according to Bob M is $475,500 per Annum. Projecting the same over 4 years. Project A Cost would be 4x $475,500 = $1,902,000

Project A for 4 years = $1,902,000

Assessment of G-Art Inc Quotation: Project B

The Quote = $ 410,000 per year. Projecting the same over 4 years. Project B Cost would be 4x $410,000 = $1,640,000

As per Richard, the company would need to incur the cost of the products/materials that it owned for running this department/unit.

a. customed graphic design and printing equipment salvage value = $ 80,000

b. remaining value of custom supplies bought a year ago (125,000*4/5) = $ 100,000

c. Savings in the rent $12,000x4 = -$ 48,000

d. Severance pay for 2 employees $60,000x2 = $ 120,000

Total cost that the company need to incur in case project B is given to GI Art Inc = a+b+c+d = $252,000

Final cost for 4 years in case project B is given to GI Art Inc = $1,640,000 + $252,000 =$ 1,892,000

Project B for 4 years = $1,892,000

The saving for the company in case the work is contracted to GI Art is $ 10,000. But the company has to let go off the senior employees and close down a business unit on the savings of only $10,000 which wouldn't be a wise decision.