Question

QualSupport Corporation manufactures seats for automobiles, vans, trucks, and various recreational vehicles. The company has a number of plants around the world, including the Denver Cover Plant, which makes seat covers.

Ted Vosilo is the plant manager of the Denver Cover Plant but also serves as the regional production manager for the company. His budget as the regional manager is charged to the Denver Cover Plant.

Vosilo has just heard that QualSupport has received a bid from an outside vendor to supply the equivalent of the entire annual output of the Denver Cover Plant for $18.58 million. Vosilo was astonished at the low outside bid because the budget for the Denver Cover Plant’s operating costs for the upcoming year was set at $21.88 million. If this bid is accepted, the Denver Cover Plant will be closed down.

The budget for Denver Cover’s operating costs for the coming year is presented below.

Denver Cover Plant Annual Budget for Operating Costs
Materials				$	7,600,000
Labor:
Direct	$	6,400,000
Supervision		430,000
Indirect plant		2,000,000			8,830,000
Overhead:
Depreciation—equipment		1,100,000
Depreciation—building		1,300,000
Pension expense		1,300,000
Plant manager and staff		550,000
Corporate expenses*		1,200,000			5,450,000
Total budgeted costs				$	21,880,000

*Fixed corporate expenses allocated to plants and other operating units based on total budgeted wage and salary costs.

Additional facts regarding the plant’s operations are as follows:

1. Due to Denver Cover’s commitment to use high-quality fabrics in all of its products, the Purchasing Department was instructed to place blanket purchase orders with major suppliers to ensure the receipt of sufficient materials for the coming year. If these orders are canceled as a consequence of the plant closing, termination charges would amount to 25% of the cost of direct materials.
2. Approximately 340 plant employees will lose their jobs if the plant is closed. This includes all of the direct laborers and supervisors as well as the plumbers, electricians, and other skilled workers classified as indirect plant workers. Some would be able to find new jobs while many others would have difficulty. All employees would have difficulty matching Denver Cover’s base pay of $11.80 per hour, which is the highest in the area. A clause in Denver Cover’s contract with the union may help some employees; the company must provide employment assistance to its former employees for 12 months after a plant closing. The estimated cost to administer this service would be $0.8 million for the year.
3. Some employees would probably choose early retirement because QualSupport has an excellent pension plan. In fact, $0.72 million of the annual pension expense would continue whether Denver Cover is open or not.
4. Vosilo and his staff would not be affected by the closing of Denver Cover. They would still be responsible for administering three other area plants.
5. If the Denver Cover Plant were closed, the company would realize about $1.9 million salvage value for the equipment and building. If the plant remains open, there are no plans to make any significant investments in new equipment or buildings. The old equipment is adequate and should last indefinitely.

Required:

2. QualSupport Corporation plans to prepare a financial analysis that will be used in deciding whether or not to close the Denver Cover Plant. Management has asked you to identify:

a. The annual budgeted costs that are relevant to the decision regarding closing the plant.

b. The annual budgeted costs that are not relevant to the decision regarding closing the plant.

c. Any nonrecurring costs that would arise due to the closing of the plant.

3. Looking at the data you have prepared in (2) above,

a. Calculate the financial advantage (disadvantage) of closing the plant.

b. Should the plant be closed?

Answer 1

2)
a) Costs that are relevant to the decision
Materials		$    7,600,000
Labor:
Direct	$             6,400,000
Supervision	$                430,000
Indirect plant	$             2,000,000	$    8,830,000
Differential pension expense (1,300,000 - 720,000)		$       580,000
Total annual relevant costs		$  17,010,000
b) Costs that are not relevant to the decision
Depreciation—equipment	$             1,100,000
Depreciation—building	$             1,300,000
Continuing Pension expense	$                720,000
Plant manager and staff	$                550,000
Corporate expenses	$             1,200,000
Total annual continuing costs	$             4,870,000
c)
Termination charges on canceled material orders ($7,600,000 x 25%)	$             1,900,000
Employment assistance	$           800,000.00
Total nonrecurring costs	$        2,700,000.00
3)
a)
	First Year	Second Year
Cost of purchasing the covers outside	$         (18,580,000)	$(18,580,000)
Costs avoided by closing the plant  (2a	$           17,010,000	$  17,010,000
Cost of closing the plant (first year non- recurring costs)	$           (2,700,000)
Salvage value of buildings and equipment	$             1,900,000
Net advantage (disadvantage) of closing the plant	$           (2,370,000)	$  (1,570,000)
b)
No, the plant should not be closed