Question

1. SWS Company currently purchases 6,000,000 units per year of a particular part from WDS Industries. The current contract sets the price at $1.00 per unit and allows one reject for each 10,000 rings purchased. SWS inspects all incoming units at a cost of $250,000 per year. The inspection station correctly identifies 100% of the acceptable units and 75% of the units that do not meet SWS’s quality criteria. Unacceptable units that pass through the inspection station lead to a shutdown in SWS’s production process during the next step. Each shutdown costs SWS an estimated $15,600 in incremental out-of-pocket costs. SWS would like to increase the incoming quality from WDS Industries to one reject per 1,000,000 units. WDS has agreed to this change but insists on a price of $1.40 per ring.

A. Under the conditions stated above, and assuming no other changes, should SWS change to the higher quality requirement? Be sure to state explicitly the criteria on which you base your decision.

B. Now assume that if SWS chooses the higher quality requirement it will eliminate the inspection station and all associated costs. Under these conditions, should SWS change to the higher quality requirement? Be sure to state explicitly the criteria on which you base your decision.

C. Now assume that, if the company changes to the higher quality requirement, the cost of a shutdown in SWS’s production process also changes. What change in the cost per shutdown would make SWS indifferent between the two quality requirements? Assume that SWS eliminates the inspection station if it chooses the higher quality requirement. Note that the cost of a shutdown does not change unless SWS changes to the higher quality requirement.

Answer 1

a. SWS should not change to the higher quality requirement as this resulting in a higher cost per unit for the company as the cost that is being incurred for rejected pieces of 15600 is being incurred regarddless of the number of the units that is being rejected. Also, as WDS has increased the cost from 1 to 1.4, this further enhances the cost per unit that SWS incurs.

b. Even in this scenario, though the inspection and other related costs are not being incurred, the cost per unit is higher in the proposed higher quality scenario and hence SWS should not change to it.

c. If the inspection station is eliminated then the cost of 250,000 is not going to be incurred anymore. However, on account of the higher quality requirement, SWS has to pay WDS 1.4 per ring which is by itself more than the cost that is being incurred in the current scenario which is 1.04,. Therefore, there is no shutdown cost at which SWS will be indifferent to the 2 scenarios as the per unit cost for a ring by itself is greater than the current cost incurred for a lower quality.