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 $8 per box. Because of excess capacity, no additional fixed manufacturing overhead costs will be incurred to produce the product. However, a $135,000 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 135,000 boxes of Chap-Off, the Accounting Department has developed the following manufacturing cost per box:

Direct material	$	3.50
Direct labor		1.80
Manufacturing overhead		1.50
Total cost	$	6.80

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 $1.50 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 30%.

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 $1.50 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 135,000 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 135,000 boxes of tubes, revised estimates show a sales volume of 167,000 boxes of tubes. At this higher sales volume, Silven would need to rent extra equipment at a cost of $52,000 per year to make the additional 32,000 boxes of tubes. Assuming that the outside supplier will not accept an order for less than 167,000 boxes of tubes, what is the financial advantage (disadvantage) in total (not per box) if Silven buys 167,000 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 $1.50 per box. How many boxes of tubes should Silven make? How many boxes of tubes should it buy from the outside supplier?

Answer 1

1) Calculation of cost it will be able to avoid by purchasing empty tubes from outside supplier:-

Decrease in Direct Material Cost (30% of $3.50)	$1.05
Decrease in Direct Labour (10% of $1.80)	$0.18
Decrease in Variable manuacturing overhead (10% of $0.50)	$0.05
Total Cost avoided by purchasing from outside supplier	$1.28

Working Note:- Separation of Manufacturing Overhead into Fixed and Variable

Total Fixed Overhead absorbed for this product given in the question = $135,000

Total Boxes Produced = 135,000

Fixed overhead absorption rate per box = $135,000/135,000 = $1.00

Variable manufacturing overhead = $1.50 - $1.00 = $0.50

2) Financial advantage (disadvantage) if it buys from outside supplier:-

Saving in manufacturing cost as calculated in part 1	$1.28
Less: Purchase price per box if purchased from outside supplier	$1.50
Financial Disadvantage of buying from outside supplier (1.28-1.50)	($0.22)

3) Financial Disadvantage in total (Amount in $)

Saving in Cost (135,000 boxes*$1.28)	172,800
Loss: Cost of purchase (135,000 boxes*$1.50)	(202,500)
Total Disadvantage	(29,700)

4) As there is a total disadvantage of $29,700 of buying the tubes from outside supplier, the company should not buy the boxes of tube from outside supplier. Thus Silven industries should make the tubes.

5) The maximum saving in cost per box of tube by buying tubes from outside supplier is $1.28, thus the company will pay upto $1.28 per box of tube only. Thus the maximum price that Silven industries would be willing to pay per box of tube is $1.28.

6) Saving in cost in case the sales volume is 167,000 (Amount in $)

Saving in Material, labor and overhead cost (167,000*$1.28) (A)	213,760
Saving in extra rent cost (B)	52,000
Total saving in cost (C = A+B)	265,760
Purchase cost from outside supplier (167,000*$1.50) (D)	250,500
Financial Advantage in buying the tubes (C-D)	15,260

7) As there is a total financial advantage of buying all the tubes from Outside of $15,260 the company should buy all the tubes from outside supplier

Number of boxes of tubes manufactured by Silven.	0
Number of boxes of tubes purchased from the outside supplier	167,000