The Minnetonka Corporation, which produces and sells to wholesalers a highly successful line of water skis, has decided to diversify to stabilize sales throughout the year. The company is considering the production of cross-country skis.
After considerable research, a cross-country ski line has been developed. Because of the conservative nature of the company management, however, Minnetonka’s president has decided to introduce only one type of the new skis for this coming winter. If the product is a success, further expansion in future years will be initiated.
The ski selected is a mass-market ski with a special binding. It will be sold to wholesalers for $80 per pair. Because of availability capacity, no additional fixed charges will be incurred to produce the skis. A $100,000 fixed charge will be absorbed by the skis, however, to allocate a fair share of the company’s present fixed costs to the new product.
Using the estimated sales and production of 10,000 pair of skis as the expected volume, the accounting department has developed the following cost per pair of skis and bindings:
Direct Labor: $35
Direct Material: $30
Total Overhead: $15
Total: $80
Minnetonka has approached a subcontractor to discuss the possibility of purchasing the bindings. The purchase price of the bindings from the subcontractor would be $5.25 per binding, or $10.50 per pair. If the Minnetonka Corporation accepts the purchase proposal, it is predicted that direct-labor and variable-overhead costs would be reduced by 10% and direct-material costs would be reduced by 20%.
1. Should the Minnetonka Corporation make or buy the bindings? Show calculations to support your answer. Provide calculations and make a decision about whether to make or buy the bindings that go on the skis. This can be done in a couple of ways.
Producing own bindings Outsource the bindings Skis + outsourced bindings
Sales: 10,000 skis, @$80 $800,000
Outsource: 20,000 bindings @ $5.25
($10.50 per pair) $105,000
Variable costs per set of skis:
Direct Material
Direct Labor
Overhead
$30
$35
$5 Outsourcing Reductions :
20% of $30=$6
10% of $35=$3.50
10% of $5=.50
Total Fixed overhead $10
Total production cost for each set of skis $80 Total outsourcing savings: $10 per set
Totals $800,000 $805,000
2. What would be the maximum purchase price acceptable to the Minnetonka Corporation for the bindings? Support your answer with an appropriate explanation.
The total amount acceptable for payment of the outsourced bindings would be $9.95 because the total savings that the company would incur from outsourcing is $10.
3. Instead of sales of 10,000 pair of skis sold at $80 a pair, revised estimates show sales volume at 12,500 pair. At this new volume, additional equipment, at an annual rental of $10,000 must be acquired to manufacture the bindings. This incremental cost would be the only additional fixed cost required even if sales increased to 30,000 pair. (This 30,000 level is the goal for the third year of production.) Under these circumstances, should the Minnetonka Corporation make or buy the bindings? Show calculations to support your answer.
Provide calculations and make a decision about whether to make or buy the bindings if you increase production to 12,500 units or 30,000 units.
a. Remember that the original fixed costs that you computed in problem 1 are not relevant in this decision, i.e. we don’t consider them. The new fixed costs are relevant.
To determine whether the Minnetonka Corporation should make or buy the bindings at a sales volume of 12,500 pairs, we need to compare the costs of both options.
1. Making the bindings:
- Sales: 12,500 skis at $80 each = $1,000,000
- Variable costs per set of skis are as follows:
- Direct Material: $30
- Direct Labor: $35
- Overhead: $5
- Total production cost for each set of skis: $30 + $35 + $5 = $70
- Total variable costs for 12,500 skis: $70 x 12,500 = $875,000
- Additional fixed cost for equipment rental: $10,000
- Total cost of producing 12,500 skis: $875,000 + $10,000 = $885,000
2. Buying the bindings:
- Sales: 12,500 skis at $80 each = $1,000,000
- Outsourcing cost for bindings: 12,500 pairs at $10.50 per pair = $131,250
- Variable cost reductions due to outsourcing are as follows:
- Direct material cost reduction: 20% of $30 = $6
- Direct labor cost reduction: 10% of $35 = $3.50
- Overhead cost reduction: 10% of $5 = $0.50
- Total variable cost savings per set of skis: $6 + $3.50 + $0.50 = $10
- Total variable cost savings for 12,500 skis: $10 x 12,500 = $125,000
- Additional fixed cost for equipment rental: $10,000
- Total cost of outsourcing 12,500 skis: $131,250 + $10,000 = $141,250
Based on these calculations, the Minnetonka Corporation should make the bindings at a sales volume of 12,500 pairs, as the cost of making the bindings ($885,000) is lower than the cost of buying the bindings ($141,250).
Now, let's calculate the cost of making or buying the bindings at a sales volume of 30,000 pairs.
1. Making the bindings:
- Variable costs for 30,000 skis remain the same: $875,000
- Additional fixed cost for equipment rental remains the same: $10,000
- Total cost of producing 30,000 skis: $885,000
2. Buying the bindings:
- Outsourcing cost for bindings: 30,000 pairs at $10.50 per pair = $315,000
- Variable cost savings per set of skis remain the same: $10
- Total variable cost savings for 30,000 skis: $10 x 30,000 = $300,000
- Additional fixed cost for equipment rental remains the same: $10,000
- Total cost of outsourcing 30,000 skis: $315,000 + $10,000 = $325,000
Based on these calculations, the Minnetonka Corporation should still make the bindings at a sales volume of 30,000 pairs, as the cost of making the bindings ($885,000) is lower than the cost of buying the bindings ($325,000).