Chapter 13, Problem 25P

Problem 6-26A Effects of the level of production on an outsourcing decision

Townsend Chemical Company makes a variety of cosmetic products, one of which is a skin cream designed to reduce the signs of aging. Townsend produces a relatively small amount (15,000 units) of the cream and is considering the purchase of the product from an outside supplier for $9 each. If Townsend purchases from the outside supplier, it would continue to sell and distribute the cream under its own brand name. Townsend’s accountant constructed the following profitability analysis:

Revenue (15,000 units × $20)	$300,000
Unit-level materials costs (15,000 units × $2.50)	(37,500)
Unit-level labor costs (15,000 units × $1,80)	(27,000)
Unit-level overhead costs (15,000 × $0.70)	(10,500)
Unit-level selling expenses (15,000 × $1,00)	(15,000)
Contribution margin	210,000
Skin cream production supervisor’s salary	(75,000)
Allocated portion of facility-level costs	(45,000)
Product-level advertising cost	(50,000)
Contribution to companywide income	$ 40,000

Required

1. a. Identify the cost items relevant to the make-or-outsource decision.
2. b. Should Townsend continue to make the product or buy it from the supplier? Support your answer by determining the change in net income if Townsend buys the cream instead of making it.
3. c. Suppose that Townsend is able to increase sales by 10,000 units (sales will increase to 25,000 units). At this level of production, should Townsend make or buy the cream? Support your answer by explaining how the increase in production affects the cost per unit.
4. d. Discuss the qualitative factors that Townsend should consider before deciding to outsource the skin cream. How can Townsend minimize the risk of establishing a relationship with an unreliable supplier?

To determine

The cost items that is relevant to make-or-outsource decision.

Explanation of Solution

Special order decisions: Special order decisions include circumstances in which the board must choose whether to acknowledge abnormal customer orders. These requests or orders normally necessitate special dispensation or include a demand for lesser price.

Decision making: It is a vital capacity in the management, since decision making is identified with issue, a compelling decision making accomplishes the preferred objectives or goals by taking care of such issues.

The cost items that are relevant to make-or-outsource decision are as follows:

The unit-level costs of creation can be avoided if the Product X is bought. Likewise, it is sensible to accept that the cost the salary of production supervisor can be avoided if the manufacturing development is rejected. Since Company TC will keep on promoting the item, the selling costs, product-level advertising cost, and facility-sustaining costs will proceed irrespective whether Product X is made or bought.

These costs may not be avoided by obtaining Product X. Thus, the below items would be relevant to the make-or-outsource decision. The items that is relevant to make-or-outsource decision is mentioned in the below part.

Determine the total avoidable costs

$\begin{array}{c}Avoidable\mathrm{Cos}t=\left[\begin{array}{l}UnitMaterial\mathrm{Cos}t+UnitLabor\mathrm{Cos}t+\\ UnitOverhead\mathrm{Cos}t+SupervisorSalary\end{array}\right]\\ =\left[\begin{array}{l}\left(\$2.50\times 15,000\right)+\left(\$1.80\times 15,000\right)+\left(\$0.70\times 15,000\right)+\\ \$75,000\end{array}\right]\\ =\left[\$37,500+\$27,000+\$10,500+\$75,000\right]\\ =\$150,000\end{array}$

Therefore the total avoidable cost is $150,000.

To determine

Whether Company TC continue to make the product or buy from the supplier by determining the change in net income.

Explanation of Solution

Determine the cost per unit

$\begin{array}{c}\mathrm{Cos}tperunit=\left[\frac{Avoidable\mathrm{Cos}t}{NumberofUnits}\right]\\ =\left[\frac{\$150,000}{15,000}\right]\\ =\$10\end{array}$

Therefore the cost per unit is $10.

Determine the increase in net income

$\begin{array}{c}IncreaseinNetIncome=\left[Avoidable\mathrm{Cos}t-\left(NumberofUnits\times Purchase\mathrm{Pr}ice\right)\right]\\ =\left[\$150,000-\left(15,000\times \$9\right)\right]\\ =\left[\$150,000-\$135,000\right]\\ =\$15,000\end{array}$

Therefore the increase in net income is $15,000.

The reason on whether Company TC would continue to make the product or buy from the supplier is as follows:

The avoidable cost of producing Product X is $10 per unit. Since the cost to buy is just $9, Company TC can lessen its costs by acquiring instead of manufacturing Product X. By outsourcing Product X would expand income by $15,000.

To determine

Whether Company TC should buy Product X if sales increase by 10,000 units.

Explanation of Solution

Determine the avoidable costs

$\begin{array}{c}Avoidable\mathrm{Cos}t=\left[\begin{array}{l}UnitMaterial\mathrm{Cos}t+UnitLabor\mathrm{Cos}t+\\ UnitOverhead\mathrm{Cos}t+SupervisorSalary\end{array}\right]\\ =\left[\begin{array}{l}\left(\$2.50\times 25,000\right)+\left(\$1.80\times 25,000\right)+\left(\$0.70\times 25,000\right)+\\ \$75,000\end{array}\right]\\ =\left[\$62,500+\$45,000+\$17,500+\$75,000\right]\\ =\$200,000\end{array}$

Therefore the avoidable cost is $200,000.

Determine the cost per unit

$\begin{array}{c}Avoidable\mathrm{Cos}t=\left[\frac{Avoidable\mathrm{Cos}t}{NumberofUnits}\right]\\ =\left[\frac{\$200,000}{25,000}\right]\\ =\$8\end{array}$

Therefore the cost per unit is $8.

The reasons on whether Company TC should buy Product X if sales increase by 10,000 units is as follows:

The cost of the chief's pay is fixed with respect to the number of units Product X is manufactured and sold. Consequently, the cost per unit will drop and there is an increase in sales. The manufacturing cost per unit is $8.

The avoidable cost per unit at the current level of production is lower to produce than to purchase. Company TC should continue making Product X. The decision to outsource should think about future development in addition to the present creation.

To determine

The qualitative factors that Company TC should consider before deciding to outsource Product X.

Explanation of Solution

The qualitative factors that Company TC should consider before deciding to outsource Product X is as follows:

Before focusing on the outsourcing decision, Company TC must think about the capacity of the provider to furnish Product X as per the organization's quality norms. Likewise, Company TC must guarantee itself that the item will be conveyed on an appropriate premise. By outsourcing, Company TC is losing the advantages of vertical integration. The organization is subject to the provider's execution.

The loss of control should be weighed in contradiction of the advantages of cost reduction. Company TC can shield itself from inconsistent providers by keeping up a rundown of licensed providers. Company TC should furnish these providers with hikes or incentives for providing exceptional services, for example, amount buys and quick invoice payment so as to increase the favored customer standing.