Question

Silven Industries, which manufactures and sells a highly successful line of summer lotions and insect repellents, has decided to diversify in order to stabilize sales throughout the year. A natural area for the company to consider is the production of winter lotions and creams to prevent dry and chapped skin.

After considerable research, a winter products line has been developed. However, Silven’s president has decided to introduce only one of the new products for this coming winter. If the product is a success, further expansion in future years will be initiated.

The product selected (called Chap-Off) is a lip balm that will be sold in a lipstick-type tube. The product will be sold to wholesalers in boxes of 24 tubes for $9 per box. Because of excess capacity, no additional fixed manufacturing overhead costs will be incurred to produce the product. However, a $139,500 charge for fixed manufacturing overhead will be absorbed by the product under the company’s absorption costing system.

Using the estimated sales and production of 155,000 boxes of Chap-Off, the Accounting Department has developed the following manufacturing cost per box:

Direct material	$	4.30
Direct labor		2.60
Manufacturing overhead		1.90
Total cost	$	8.80

The costs above relate to making both the lip balm and the tube that contains it. As an alternative to making the tubes for Chap-Off, Silven has approached a supplier to discuss the possibility of buying the tubes. The purchase price of the supplier's empty tubes would be $1.35 per box of 24 tubes. If Silven Industries stops making the tubes and buys them from the outside supplier, its direct labor and variable manufacturing overhead costs per box of Chap-Off would be reduced by 10% and its direct materials costs would be reduced by 20%.

Required:

1. If Silven buys its tubes from the outside supplier, how much of its own Chap-Off manufacturing costs per box will it be able to avoid? (Hint: You need to separate the manufacturing overhead of $1.90 per box that is shown above into its variable and fixed components to derive the correct answer.)

2. What is the financial advantage (disadvantage) per box of Chap-Off if Silven buys its tubes from the outside supplier?

3. What is the financial advantage (disadvantage) in total (not per box) if Silven buys 155,000 boxes of tubes from the outside supplier?

4. Should Silven Industries make or buy the tubes?

5. What is the maximum price that Silven should be willing to pay the outside supplier for a box of 24 tubes?

6. Instead of sales of 155,000 boxes of tubes, revised estimates show a sales volume of 191,000 boxes of tubes. At this higher sales volume, Silven would need to rent extra equipment at a cost of $56,000 per year to make the additional 36,000 boxes of tubes. Assuming that the outside supplier will not accept an order for less than 191,000 boxes of tubes, what is the financial advantage (disadvantage) in total (not per box) if Silven buys 191,000 boxes of tubes from the outside supplier? Given this new information, should Silven Industries make or buy the tubes?

7. Refer to the data in (6) above. Assume that the outside supplier will accept an order of any size for the tubes at a price of $1.35 per box. How many boxes of tubes should Silven make? How many boxes of tubes should it buy from the outside supplier?

Answer 1

Answer to Part 1,2,3 and 4 combined below.

The $139500 in fixed overhead cost charged to the new product is a common cost that will be the same whether the tubes are produced internally or purchased from the outside. Hence, it is not relevant. The variable manufacturing overhead per box of Chap-Off would be $0.50, as shown below:

Total manufacturing overhead cost per box of Chap-Off $1.9

Less fixed portion ($139500 ÷ 155,000 boxes)                            0.9

Variable overhead cost per box $1.0

The total variable cost of producing one box of Chap-Off would be:

Direct materials                                  $4.3

Direct Labor $2.6

Variable manufacturing overhead $1.0

Total variable cost per box $7.9

If the tubes for the Chap-Off are purchased from the outside supplier, then the variable cost per box of Chap-Off would be:

Direct materials (4.3*80%) =$3.44

Direct Labor (2.6*90%) =$2.34

Variable manufacturing overhead (1*90%) =$0.9

Cost of tube from outside =$1.35

Total Variable cost per box =$8.03

Therefore, the company should reject the outside supplier’s offer. A savings of $0.13 per box of Chap-Off will be realized by producing the tubes internally.

If the company buys 155000 boxes from uotside supplier, it has a financial disadvantage of (155000*0.13)=$20150

5) Maximum price Silver should be willing to pay is the costs avoided

(Direct materials $4.30*20%+Direct labor $2.6*10%+Variable Manufacturing OH $1.0*10%) = $1.22

To make purchasing the tubes attractive, however, the purchase price should be less than $1.22 per box.

6)

At a volume of 191,000 boxes, the company should buy the tubes. The computations are:

Cost of making 191,000 boxes:

191,000 boxes × $1.22 per box                  =$233020

Rental cost of equipment                            =$56000

Total Cost =$289020

Cost of buying the boxes (191000*1.35) =$257850

Thus buying the boxes will save the company $31170 per year.

7)

Under these circumstances, the company should make the 155,000 boxes of tubes and purchase the remaining 36,000 boxes from the outside supplier. The costs would:

Cost of making: 155,000 boxes × $1.22 per box          =$189100

Cost of buying: 36,000 boxes × $1.35 per box =$48600

Total Cost =$237700

Because the amount of cost under this alternative is $20,150 less than the best alternative, the company should make as many tubes as possible with the current equipment and buy the remaining tubes from the outside supplier.