Question

Problem 12-23 Make or Buy Decision [LO12-3]

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 $10 per box. Because of excess capacity, no additional fixed manufacturing overhead costs will be incurred to produce the product. However, a $128,000 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 160,000 boxes of Chap-Off, the Accounting Department has developed the following manufacturing cost per box:

Direct material	$	4.50
Direct labor		2.80
Manufacturing overhead		2.00
Total cost	$	9.30

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 $1.40 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:

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 160,000 boxes of tubes, revised estimates show a sales volume of 197,000 boxes of tubes. At this higher sales volume, Silven would need to rent extra equipment at a cost of $57,000 per year to make the additional 37,000 boxes of tubes. Assuming that the outside supplier will not accept an order for less than 197,000 boxes of tubes, what is the financial advantage (disadvantage) in total (not per box) if Silven buys 197,000 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 $1.40 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 5:

Maximum price that Silven should be willing to pay the outside supplier for a box of 24 tubes

Cost per Box including tube:

	Inhouse Tube Mfg.	Purchase of Tube
Direct Material	4.5	3.6
Purchse Cost of Tube	0	1.4
Direct Labour	2.8	2.52
Variable Mfg. Overhead	1.2	1.08
	8.5	8.6

There is net savings of $ 0.10 per box of tube if the same is manufactured by silven.

Hence, the maximum price that silven can pay the outside supplier for a box of 24 tubes is $1.30 (1.40-0.10)

Answer 6:

Assumption: Silven buys 197,000 boxes of tubes from the outside supplier

There will be additional cost of $ 0.10 per box of tube if the same is purchased from outside supplier. So total additional cost will be $ 19,700 (197,000 * 0.10)

Savings on account of purchase from outside supplier will be $ 57,000 (rent extra equipment at a cost of $57,000 per year)

Thus, net advantage from procuring tube from outside supplier is $ 37,300 (57000-19700)

Accordingly, Silven should buy the tubes from outside supplier

Answer 7:

Assumption: Outside supplier will accept an order of any size for the tubes at a price of $1.40 per box

Since, there is net savings of $ 0.10 per box of tube if the same is manufactured by silven upto the limit of 160,000 boxes.

Hence, Silven should manufacture 160,000 boxes of tubes by itself and purchase remaining boxes of tubes i.e. 37,000 boxes form outside supplier @ 1.40 per box