Question

Factory Closing Decision

The Dough Knot Corporation bakes breads, pastries, cookies and every other baked good imaginable. The company has a number of factories around the world, including the LACC Cookie Factory, which makes... cookies.

Michael Schrute is the factory manager of the LACC Cookie Factory but also serves as the regional production manager for the company. His budget as the regional manager is charged to the LACC Cookie Factory.

Schrute has just heard that The Dough Knot has received a bid from an outside vendor to supply the equivalent of the entire annual output of the LACC Cookie Factory for $34 million. Schrute was astonished at the low outside bid because the budget for the LACC Cookie Factory’s operating costs for the upcoming year was set at $50.3 million. If this bid is accepted, the LACC Cookie Factory will be closed down.

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

LACC Cookie Factory Annual Budget for Operating Costs

Baking flour	2,500,000
Butter	3,700,000
Chocolate	2,400,000
Sugar	6,000,000
Baking Employees	12,000,000
Cleaning Employees	1,500,000
Security Employees	3,000,000
Supervisors	1,000,000
Factory Manager and Staff	900,000
Pension Expense	4,000,000
Corporate Expense	3,800,000
Depreciation-Building	6,000,000
Depreciation-Equipment	3,500,000
Total Budgeted Costs	50,300,000

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

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

A. Due to LACC Cookie’s commitment to use high-quality ingredients 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 factory closing, termination charges would amount to 25% of the cost of direct materials.

B. Approximately 400 factory employees will lose their jobs if the factory is closed. This includes all of the direct laborers and supervisors as well as the plumbers, electricians, and other skilled workers classified as indirect factory workers. Some would be able to find new jobs while many others would have difficulty. All employees would have difficulty matching LACC Cookie’s base pay of $18.80 per hour, which is the highest in the area. A clause in LACC Cookie’s contract with the union may help some employees; the company must provide employment assistance to its former employees for 12 months after a factory closing. The estimated cost to administer this service would be $1.6 million for the year.

C. Some employees would probably choose early retirement because The Dough Knot has an excellent pension plan. In fact, $2.5 million of the annual pension expense would continue whether LACC Cookie is open or not.

D. Schrute and his staff would not be affected by the closing of LACC Cover. They would still be responsible for administering three other area factories.

E. If the LACC Cookie Factory were closed, the company would realize about $3.3 million salvage value for the equipment and building. If the factory 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:

The Dough Knot Corporation plans to prepare a financial analysis that will be used in deciding whether or not to close the LACC Cookie Factory. Management has asked you to identify:

1. Without regard to costs, identify the advantages to Dough Knot Corporation of continuing to operate LACC Cookie Factory (200 word minimum).

2. The annual budgeted costs that are relevant to the decision regarding closing the factory.

3. The annual budgeted costs that are not relevant to the decision regarding closing the factory.

4. Any nonrecurring costs that would arise due to the closing of the factory. Looking at the data you have prepared above,

5. Calculate the financial advantage (disadvantage) of closing the factory.

6. Should the factory be closed? Explain your calculations and support your argument. It’s your job to convince the CEO of your decision (500 words minimum).

(Part of your score will be based on your ability to argue your strategy. You may come to the correct numerical calculation, but if you cannot convey your message your recommendation will fall flat with the CEO. The word minimums refer to #1 and #6. For questions 2-5, you should show your calculations and support your argument, as if you were making a presentation to management.)

Answer 1

Ans 2/Ans 5./Ans 6.
Annual Estimate of relevant costs
Details	Relevant Cost of Running LACC Cookie Factory	Relevant costs for Closing Cookie Factory & Buying from Outside vendor (Unavoidable costs)	Avoidable costs if LACC Closed	Remarks
Baking Flour	2,500,000	625,000		25% cancellation charge
Butter	3,700,000	925,000		25% cancellation charge
Chocolate	2,400,000	600,000		25% cancellation charge
Sugar	6,000,000	1,500,000		25% cancellation charge
Baking Employees	12,000,000	-
Cleaning Employees	1,500,000
Security employees	3,000,000
Supervisors	1,000,000
Cost for administering employee assitance	-	1,600,000		Only applicable if LACC closed
Pension Expense	1,500,000			Out of $4M , $2.5M is irrelevant as unavoidable
Cost of Buying from outside vendor		34,000,000
Salvage value from Equipments		(3,300,000)
Total Relevant costs	33,600,000	35,950,000

Ans 1.
1. The advantages of operating Dough Knot Corp in operating LACC cookie factory are;
a. The company can maintain the quality of the cookies in a better way when the operartions are in its control.
b. It can go for adding new varieties with change in recipe which will remain trade secret.
c. It can vary the production volume as per demand fluctuation without any huge inventory impact.
d. It can better manage the production schedule to match the supply chain requirements.
e. It can maintain a reputaion as high paying employer and attarct nest talents
f. It can be free from the dependence of key material supply from a single vendor.

Ans 2.

The relevant budgeted costs are

1. Direct Material costs

2. Direct and indirect labor costs

3. Employment assitance cost

4. $1.5M of Pension expense cost

5. Salvage value of equipment if LACC is closed

6.Cost of buying from outside vendor

Ans 3.

The non relevant costs are ;

1. Factory Manager & Staff cost

2. Corporate expense

3. depreciation cost

4. $2.5M of fixed Pension expense

Ans4.
The non recurring cost arsising out of factory closure is the
employment assistance cost of $1.6M

Ans 5.
Analysis given above

Ans 6.
Based on the analysis above, the relevant cost of running
LACC is is less than the relvant costs of buying the cookies from
outside.
We can notice the costs that are remaining even after we decide
to close the LACC factory. 25% of direct expense amounting to
$3.65 Million will sticll be there for next year as PO cancellation charge.
We can get rid of the direct labours , but still we need to spend
the employment assistance amount of $1.6M.
The fixed costs like Factory Manager & Staff cost , Corporate expense ,
Depreciation etc will continue whether we run LACC or close it .
The amount of such cost is $10.2M. For pension expense $2.5M
of cost will continue even if we close LACC.
Apart from these continuing costs , we shall bear the cost of getting
the cookies outside. Due the high incidence of Fixed unavoidable costs,
the benefit of closing LACC is lost and ultimately
running LACC is proving benenficial.
Considering the finacial aspects as well as the other factors as detailed
above , it is advisable to run LACC, rather than closing it.