Question

Cool Sphere produces many types of fans. A model that has proven to be quite popular is the Retractafan. This is a fan with retractable blades. Michael is now looking closely at its production of retractable fans, which included 10,000 units in the prior year. Cool Sphere has the capacity to produce 15,000 Retractafan per year. The following table is based on 10,000 units that they produced last year and includes $100,000 of allocated fixed manufacturing overhead. The selling and administrative cost of $20.00 per fan includes (at a sales level of 10,000 units) fixed costs of $6.00 per unit.

Selling price per unit $ 72.00

Costs per unit:

Electric motor $ 6.00

Other parts 8.00

Direct labour ($15/hour) 15.00

Manufacturing overhead 15.00

Selling and administrative costs 20.00 64.00

Profit per unit $ 8.00

Michael believes that in the coming year, demand for the retractable fans will be 20,000 units. Cool Sphere has looked into the possibility of purchasing the retractable fans from another manufacturer to help it meet this demand. Blowhard, a steady supplier of quality products, would be able to supply up to 9,000 retractable fans per year at a price of $46.00 per unit, delivered to Cool Sphere’s facility.

Look,” Michael said to you. “I need you to work out for me what these all mean. My accounts team knows how to put in the numbers, but it seems like no one knows what to do with it. Is that how much it really costs me to produce a fan? If so, then Blowhard must be doing something different to be able to charge me such a low price. Can you re-work those numbers and tell me how much each of the Retractafans cost?”
As you nodded your head, Michael continued: “As I have told Maureen, demand is going to go up to 20,000 units next year. But I only have the capacity for 15,000 units. So what should I do? I know we can buy some from Blowhard to make up the 20,000 units requirement, but how many should I buy? Blowhard has said they can supply me with up to 9,000 units. If the price they are quoting me is lower than how much it cost me to produce, then maybe I should just buy from Blowhard and then produce the remainder. Tell me how many I need to buy. Give me a plan of how many to make and how many to buy and show me what is the maximum contribution margin I can make.”
“And one last thing,” Michael went on. “Is there anything else I should consider apart from the price of the fans from Blowhard? Maureen always talks about these so-called “qualitative factors”. Maybe consider them for me as well? ”

Answer 1

i) Relevant costs are cots that relates to a specific management decision. The costs vary proportionally with the change in decisions. These costs must not be avoidable when manufacturing the retractafan. They equates to the variable cots/Direct costs of manufacture.

Relevant costs in the manufacture of each Retractafan are:
Costs of Electric motor = $6.00
Cost of other parts = $8.00
Direct labor ($15/hour) = $15.00
Selling & Admin ($20 – $6) = $14.00
Total Relevant Costs = $43.00

ii) The price offered by Blowhard of $46.00 is higher than the relevant costs of producing. Therefore, Michael should minimize the number of units to be out sourced from Blowhard.
Since he has a maximum capacity of 15 000, the following is recommended.

Production plan
Produce to maximum capacity of 15 000 units

Purchase plan
Purchase the difference of demand and production capacity
= 20 000 – 15 000
= 5 000 units only from Blowhards

The maximum contribution margin:
Variable costs = (15 000 * 43) + (5 000 * 46)
= $875 000

Adjusted unit variable cost = 875 000/20 000
= $43.75

Maximum contribution = (72 – 43.75)/72
= 28.25/72
= 0.3923611111 * 100
= 39.23611111%
= 39.24%

Buying more than 5000 units from Blowhard will increase unit variable costs and reduce the contribution

iii) there are several qualitative to be considered when considering the decision to outsource from Blowhard and these include the quality of its products, reliability of supplies, efficiency and speed in delivery, and how trustworthy is Blowhard.
Quality is important and Michael should reach his final decision of considering outsourcing addition units from Blowhard if he meets quality standards. Poor quality products will erode his corporate image and goodwill which will negatively impact his success.



Reliability of supplies includes the timely availability of supplies by Blowhard. Failure to get deliveries on time from Blowhard will leads to customer disappointment on Michael’s part and will definitely leads to his loyal customers trying other rival firms. Therefore it is crucial to see that Blowhard is ready to supply stocks just in time as Michael place orders.

To also consider is the trustworthy of Blowhard. Trustworthy is a fundamental business principle. Dealing with untrustworthy supplier will result in Michael suffering high costs due to lack of honest and integrity from supplier leading to either poor quality goods or some uncomely business practices.

Finally, Michael should consider the speed and efficiency in delivery of orders by Blowhard. Do Blowhard deliver orders in time, are there any delays, and is the delivery reliable and always available. Therefore, background check of blowhard is necessary.