You are an accounting consultant with Numbers-R-Us LLP, a firm of independent accounting and management consultants. You have been asked by one of your clients – Ms. Kali St. Laurent, the president of ABC Widgets Inc. in North Bay, Ont. – for some advice.
ABC Widgets manufactures 750,000 kronks a year. Kronks are metal parts which are used in making widgets; one kronk is included in each widget. ABC uses these kronks to make the widgets it sells to customers across Canada.
ABC has been approached by Dr. Lester Meighen, the president of Meighen Kronks Corp., a manufacturer of kronks. Dr. Meighen has offered to sell kronks to ABC for $10 each (including the shipping costs). Meighen could ship the kronks to ABC within one week of the order, and offers a two-year warranty on each kronk. Dr. Meighen has guaranteed the price for two years.
Currently, ABC makes the kronks in a specially-designed area in its factory in North Bay. Each kronk costs $14 to make (see the summary at the end of this document). Ms. St. Laurent wants you to recommend whether ABC should buy the kronks from Meighen or continue to make the kronks itself.
You gathered the following information in your research. Some of the data may be useful in your decision; some may be irrelevant.
ABC sells its widget at prices between $65 and $75 each. ABC’s main competitors charge between $45 and $55. ABC can charge higher prices because it offers the highest-quality widgets, a five-year warranty, and delivery within two days of the order.
ABC currently sells 750,000 widgets a year. ABC’s profit on each widget is $20.
In response to its customers’ requests, ABC designs several new models of widgets each year. Each new widget design requires some modifications in the kronks. Meighen can make these design changes at no cost if it is given one month’s notice.
Kronks are large, and take up a lot of storage room. Therefore, ABC makes kronks in small batches as they are needed.
If ABC buys widgets from Meighen, the factory space used to make kronks will not be used. ABC can save about $50,000 a year in heating and electricity costs if it shuts down this part of the factory; total heating and lighting costs for the entire factory average $300,000 a year.
If ABC buys the widgets, it will lay off the six long-time employees responsible for making the kronks, each of whom earns $50,000 annually. The one-time severance cost will be $120,000. Ms. St. Laurent does not believe that any other labour costs will change.
The machinery used by ABC to make kronks was bought in 2010 for $1,500,000. It has an expected useful life of 15 years, with no disposal value after that. ABC believes it can sell the machinery to another widget manufacturer; the net proceeds would be $150,000.
Meighen Kronks Corp. is well-known for making better-than-average kronks in large quantities. It has been in business for 20 years.
Please help me make a brief letter of recommendation to Ms. St. Laurent.
TABLE 1: COST OF MAKING KRONKS
Direct labour $6.75
Direct material 5.25
Overhead allocated* 2.00
TOTAL UNIT COST $14.00
*Includes all factory and administrative overhead.